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1 The Basics of Capital Budgeting: Evaluating and Estimating Cash Flows Corporate Finance Dr. A. DeMaskey Should we build this plant?

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2 Learning Objectives Questions to be answered: What is capital budgeting? How are investments classified? What methods are used to rank projects? What are the relevant cash flows of a project? What principles underlie the estimation of cash flows? What types of cash flows must be considered when evaluating a proposed project?

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3 Capital Budgeting Investment decision making process, which involves fixed assets. Capital Capital budget Long-term decisions Sizable cash outlays Difficult to reverse Important to firm’s future Profitability Growth and Survival Future direction

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4 The Five Stages of Capital Budgeting Stage 1: Investment screening and selection Stage 2: Capital budgeting proposal Stage 3: Budget approval and authorization Stage 4: Project tracking Stage 5: Post completion audit

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5 Project Classification According to economic life: Short-term Long-term According to risk: Replacement projects Expansion projects New products and markets Mandated projects According to dependence on other projects: Independent projects Mutually exclusive projects Contingent projects Complementary projects According to cash flows: Normal cash flow projects Nonnormal cash flow projects

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6 Steps 1.Estimate the CFs (inflows & outflows). 2.Assess the riskiness of the CFs. 3.Determine the appropriate discount rate, k = WACC for project. 4.Find NPV and/or IRR. 5.Accept if NPV > 0 and/or IRR > WACC.

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7 Investment Evaluation Techniques Payback Period (PB) Discounted Payback Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR)

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8 Characteristics of an Evaluation Technique Considers all future incremental cash flows from a project. Considers the time value of money. Considers the uncertainty associated with future cash flows.

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9 Payback Period The length of time it takes to recover the initial investment outlay. Equal cash flows Unequal cash flows Payoff or capital recovery period

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10 Evaluation of Payback Period Strengths Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the TVM. Ignores CFs occurring after the payback period.

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11 Discounted Payback Period Uses discounted rather than raw CFs. The length of time it takes to recover the project’s investment in terms of discounted cash flows, where the discount rate is the cost of capital.

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12 Evaluation of Discounted Payback Period Strengths Considers the time value of money. Considers the riskiness of the cash flows involved in the payback. Weaknesses Requires estimate of cost of capital. Ignores cash flows beyond the payback.

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13 Net Present Value (NPV) The sum of the present value of all expected cash flows, where the discount rate is the cost of capital. Cost often is CF 0 and is negative.

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14 Rationale for NPV Method NPV = PV inflows – Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

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15 Evaluation of NPV Strengths Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows. Weaknesses Requires estimate of cost of capital. Expressed in terms of dollars, not as a percentage.

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16 Net Present Value Profile Graphical depiction of the NPV for different discount rates. Downward sloping Slightly curved Crossover discount rate

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17 Profitability Index (PI) Ratio of the present value of the change in operating cash flows to the present value of the investment cash outflow. PI vs. NPV

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18 Rationale for PI Method PI = PV inflows / Cost = Benefit-cost ratio Accept project if PI > 1 Useful in case of capital rationing

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19 Evaluation of PI Method Strengths Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows. Weaknesses Requires estimate of cost of capital. May not give correct decision for mutually exclusive projects.

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20 Internal Rate of Return The discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR. Annualized yield on an investment.

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21 Rationale for IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost -- some return is left over to boost stockholders’ returns. Example:WACC = 10%, IRR = 15%. Profitable. IRR acceptance criteria: If IRR > k, accept project. If IRR < k, reject project.

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22 IRR vs. NPV Ranking conflict for mutually exclusive projects Reinvestment rate assumption –NPV assumes reinvest at k (opportunity cost of capital). –IRR assumes reinvest at IRR. –Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. Causes: –Different timing in cash flows –Scale differences

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23 Evaluation of IRR Method Strengths Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows. Weaknesses Requires estimate of cost of capital. May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing. May produce multiple IRRs.

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24 Modified Internal Rate of Return (MIRR) The discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. The internal rate of return on a project assuming that cash inflows are reinvested at some specified rate.

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25 MIRR vs. IRR MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.

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26 Evaluation of MIRR Method Strengths Tells whether firm value is increased. Considers all cash flows. Considers the time value of money. Considers the riskiness of future cash flows. Weaknesses May not give value-maximizing decisions for mutually exclusive projects. May not give value-maximizing decisions under capital rationing.

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27 Capital Budgeting in Practice IRR is most commonly used. Managers like rates -- prefer IRR to NPV comparisons. More than one evaluation technique is used. NPV is used most often.

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28 Principles of Estimating Cash Flows Incremental Cash Flows After-Tax Cash Flows Ignore Sunk Costs Include the Opportunity Cost Include Externalities

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29 Assumptions End-of period cash flows Project assets are purchased and put to work immediately Equally-risky cash flows

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30 Types of Cash Flows Initial Investment Outlay Operating Cash Flows Terminal Cash Flows Net Cash Flows

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31 01234 Initial Outlay OCF 1 OCF 2 OCF 3 OCF 4 + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4 Project Cash Flows

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32 Net Investment Cost of Asset + Shipping Costs + Installation Costs PLUS Increase/decrease in Working Capital

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33 Operating Cash Flows Method 1: OCF = ( R - E - D)(1 - T) + D Method 2: OCF = ( R - E)(1 - T) + DT

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34 Terminal Cash Flows Funds Realized from Sale of New Asset + Tax Consequences from the Sale of the Asset PLUS Recovery of Net Working Capital

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35 Real vs. Nominal Cash Flows In DCF analysis, k includes an estimate of inflation. If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. This bias may offset the optimistic bias of management.

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36 Multinational Capital Budgeting Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes. Foreign projects are subject to political risk. Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.

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Chapter 10: The Basics Of Capital Budgeting. 2 The Basics Of Capital Budgeting :

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