Presentation on theme: "International Center For Environmental Finance."— Presentation transcript:
1International Center For Environmental Finance. Environmental Finance PolicyPresentation #?:Capital Budgeting Decisions
2CAPITAL BUDGETINGCapital Budgeting is used to describe how managers plan projects that have long-term implications such as the purchase of new equipment and the introduction of new products or services.Managers have many potential projects that can be funded, hence, they must carefully select those projects that promise the greatest future return.
3Typical Capital Budgeting Decisions Cost reduction decisions. Should new equipment be purchased to reduce costs?Expansion decisions. Should a new plant, warehouse, or other facility be acquired or built to increase capacity and sales?Equipment selection decisions. Which of several available machines would be the most cost effective purchase?Lease or buy decisions. Should new equipment be leased or purchased ?Equipment replacement decisions. Should old equipment be replaced now or later?
4Discounted Cash FlowThere are two approaches to making capital budgeting decisions by means of discounted cash flow.The net present valueThe internal rate of return
5The Net Present Value Method Net present value is the difference between an investment’s market value and its cost.In other words, net present value is a measure of how much value is created or added today by undertaking an investment, which will determine whether or not the project is an acceptable investment.
6The Net Present Value Method Example 1Moscow City Vodokanal is considering the purchase of a machine that will bring cash revenues of $20,000 per year. Cash costs (including taxes) will be $14,000 per year. The life of the machine is 8 years and its salvage cost will be $2,000. The project cost $30,000 to launch. We will use 15% discount rate.Should the machine be purchased?If there are 1,000 shares of stock outstanding, what will be the effect on price per share for taking this investment?
7The Net Present Value Method It may appear that the answer is obvious, since we pay only $30,00 for revenue of 8x($20,000-$14,000)+$2,000=$50,000However, it is not that obvious.To see if this investment is acceptable we have to perform Net Present Value Analysis
8The Net Present Value Method We need to calculate the present value of the future cash flows at 15 percent.The net cash inflow will be $20,000 cash income less $14,000 in costs per year for eight years.We have an eight-year annuity of$20,000-$14,000=$6,000 per year, along with a single lump-sum inflow of $2,000 in eight years.
9The Net Present Value Method Time(years)12345678Initial cost($30)Inflow$20Outflow-14Net inflow$6SalvageNet cash flow$8
10The Net Present Value Method Present Value = $6,000x[1-(1/1.158)/0.15++(2,000/1.158)=($6,000 x )++(2,000/3.0590)=$26, ==$27,578When we compare this to the $30,000 estimated cost ,we se that the NPV is:NPV=-$30, ,578 = -$2,422Therefore, this is not a good investment
11The Net Present Value Method Now, lets answer the question regarding how this investment affect the value of our stock.It will decrease the total value of our stock by $2,422. With 1,000 shares outstanding, we should expect a loss of value of$2,422/1,000 = $2,42 per share
12The Net Present Value Method Summary:If the Net Present Value Is …Then the Project Is…PositiveAcceptable, since it promisesa return grater than therequired rate of returnZeroa return equal the requiredrate of returnNegativeNot acceptable, since itpromises a return less thanthe required rate of return
13The Net Present Value Method Example 2Now let us consider an example that has different cash inflows in different periods.Suppose we are asked to decide whether or not a new consumer service product should be launched.Based on projected sales and costs, we expect that the CF over the 5 year life of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year.It will cost $10,000 to begin operation and we use 10% discount rate.WHAT SHOULD WE DO?
14The Net Present Value Method Given the cash flows and discount rate, we can calculate the total value of the product by discounting the cash flows back to the present.Present Value = ($2,000/1.1) + (2,000/1.12) ++ (4,000/1.13) + (4,000/1.14) + (5,000/1.15)== $1, , , , ,105 == $12,313NPV = $12,313 – 10,000 - $2,313
15Importance of Cash Flows Although, the accounting net income figure is useful for many things, it is not used in discounted cash flow analysis.The reason is that accounting net income is based on accrual concepts that ignore the timing of cash flows into and out of an organization.The timing of cash flows is important, since a dollar received today is more valuable than a dollar received in the future.Therefore, instead of determining accounting net income, the manager must concentrate on identifying the specific cash flows associated with an investment project.
16Cash OutflowsMost projects will have an immediate cash outflow in the form of an initial investment in equipment or other assets.In addition, some projects require expansion of the working capital.Also, many projects require periodic repairs and maintenance and additional periodic costs – these should be treated as cash outflows.
17Cash Outflows Cash Outflows: Initial investment Increased working capital needsRepairs and maintenanceIncremental operating costs
18Cash InflowsAny sound project will normally either increase revenues or reduce costs. And the amount involved should be treated as a cash inflow.Cash inflows are also frequently realized from salvage of equipment when the project is terminated.Also, upon termination of a project, any working capital that was tied up to the project can be released to for use elsewhere and should be trayed as cash inflow.
19Cash Inflows Cash Inflows: Incremental revenues Reduction in costs. Salvage valueRelease of working capital
20Choosing a Discount Rate To use the net present value method, we must choose some rate of return for discounting cash flows to their present value.The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate.The cost of capital is the average rate of return the company must pay to its long term creditors for the use of their funds.
21Extended Example of the NPV Method GorVodokanal has an opportunity to offer new service to an industrial client, but has to purchase supplies and equipment from a chemical manufacturer in order to provide that service.The contract between all 3 parties is for 5 years with an option for renew.GorVodokanal is responsible for all costs of promotion and distribution of its new service.After careful study, GorVodokanal has estimated that the following costs and revenues would be associated with the new service:
22Extended Example of the NPV Method Cost of equipment needed$60,000Working capital needed100,000Overhaul of the equipment in four years5,000Salvage value of the equipment in five years10,000Annual revenue and costs:Sales revenues200,000Cost of goods sold125,000Out of pocket operating costs (for salaries,advertising, and other direct costs)35,000
23Extended Example of the NPV Method At the end of the five-year period, the working capital would be released for investment elsewhere if contract will not be renewed.GorVodokanal’s discount rate and cost of capital is 20%.Would you recommend that GorVodokanal undertakes this project?
24Extended Example of the NPV Method Sales revenue$200,000Less cost of goods sold125,000Less out-of-pocket costs for salaries,advertising, etc.35,000Annual net cash inflows$40,000
25Extended Example of the NPV Method ItemYear(s)Amount ofCashFlows20%FactorPresentValue ofCash FlowsPurchase of equipmentNow($60,000)1Working capital needed-100,000Overhaul of equipment4-5,0000.482*-2,410Annual net cash inflowsfrom sales of the productLine1-540,0002.991^119,640Salvage value of theequipment510,0000.402*4,020Working capital released100,00040,200Net present value$1,450
26Extended Example of the NPV Method *From Present Value and ^Present Value of an Annuity TablesNotice how working capital is handled in this exhibit. It is counted as a cash outflow at the beginning of the project and as a cash inflow when it is released at the end of the project.
27Discounted Cash Flows –The Internal Rate of Return Method
28The Internal Rate of Return Method The internal rate of return (IRR) method can be defined as the interest yield promised by an investment project over its useful life.The IRR is computed by finding the discount rate that equates the present value of a project’s cash outflows with the present value of its cash inflows.In other words, the IRR is that discount rate that will cause the NPV of a project to be equal zero.
29The Internal Rate of Return Method Example 4GorVodokanal is considering the purchase of automatic water purification machine. At present, water is purified in a small labor intensive machine.The new machine would cost 16,950 and will have a useful life of 10 years.The new machine would do the job much more quickly and would result in labor savings of $3,000 per year
30The Internal Rate of Return Method Initial cost$16,950Life of the project (years)10Annual cost savings$3,000Salvage value
31The Internal Rate of Return Method To compute IRR promised by the new machine, we must find the discount rate that will cause NPV of the project to be zero.To do that, we need to divide the investment in the project by the expected net annual cash inflow. This computation will give us a factor from which the IRR can be determined.Factor of the IRR =Investment Required=$16,9505.65Net annual cash inflow$3,000
32The Internal Rate of Return Method Thus, from our computations, the discount factor that will equate a series of $3,000 cash inflows with a present investment of $16,950 is 5.65.Now, we need to find this factor in Present Value of an Annuity Table to see what rate of return it represents.We should use the 10 period line in Present Value of an Annuity Table since the cash flows for the project continue for 10 years.
33Present Value of an Annuity Table Period4%5%6%8%10%12%14%10.9620.9520.9430.9260.9090.8930.87721.8861.8591.8331.7831.7361.691.64732.7752.7232.6732.5772.4872.4022.32243.633.5463.4653.3123.173.0372.91454.4524.2122.9933.7913.6053.43365.2425.0764.9174.6234.3554.1113.88976.0025.7865.5825.2064.8684.5644.28886.7336.4636.215.7475.3354.9684.63997.4357.1086.8026.2475.7595.3234.946108.1117.7227.366.716.1455.6505.216118.768.3067.8877.1396.4955.9885.453
34The Internal Rate of Return Method As we can see from Present Value of Annuity Table the internal rate of return promised by the water purification machine project is 12%.We can verify this by computing the project’s net present value using a 12% discount return
36The Internal Rate of Return Method Once the IRR has been computed, what does the manager should do with the information?The IRR should be compared to the company’s required rate of return, which is the minimum rate of return that an investment project must yield to be acceptable.If the IRR is equal or greater than the required rate of return, then the project is acceptable.If the IRR is less than the required rate of return, then the project is rejected.
37The NPV of Return Method The NPV method can be used to compare competing investment projects in two ways.total-cost approachincremental-cost approach
38The Total Cost Approach Example 5GorVodokanal has one of its pipe networks in poor condition. This pipe network can be renovated at an immediate cost of $20,000. Further repairs and maintenance will be needed five years from now at a cost of $8,000. In all, this pipe network will be usable for 10 years if this work is done. At the end of 10 years, the pipe network will be scrapped at a salvage value of $6,000. The scrap value now is $7,000. It will cost $30,000 each year to operate pipe network, and revenues will total $40,000 annually
39The Total Cost Approach Alternative: GorVodokanal can purchase a new pipe network at a cost of $36,000. The new pipe network will have a life of 10 years and will require some repairs at the end of 5 years and will amount to $3,000. At the end of 10 years, it is estimated that the scrap value would be $6,000. It will cost $21,000 each year to operate the pipe network, and revenues will total $40,000 annually.GorVodokanal requires a return of at least 18% on all investment capital.
40The Total Cost Approach New Pipe NetworkOld Pipe NetworkAnnual revenues$40,000Annual cash operating costs21,00030,000Net annual cash inflows$19,000$10,000
41The Total Cost Approach ItemYear(s)Amountof CashFlows18%Factor*PV ofCashBuy the new pipe network:Initial investmentNow($36,000)1.000Repairs in 5 years5($3,000)0.437($1,311)Net annual cash inflows1-1019,0004.49485,386Salvage of the old network7,000Salvage of the new network106,0000.1911,146Net present value$56,221
42The Total Cost Approach ItemYear(s)Amountof CashFlows18%Factor*PV ofCashKeep the old pipe network:Initial repairsNow($20,000)1.000Repairs in five years5($8,000)0.437($3,494)Net annual cash inflows1-1010,0004.49444,940Salvage of the old network106,0000.1911,146Net present value$22,590
43The Total Cost Approach NPV of the New Pipe Network$56,221NPV of the Old Pipe Network$22,590NPV in favor of buying the New Network$33,631
44The Incremental Cost Approach When only two alternatives are being considered, the incremental cost approach offers a simpler and more direct decision.Unlike the total cost approach, it focuses only on differential costs.
45The Incremental Cost Approach ItemYear(s)Amountof CashFlows18%Factor*PV ofCashIncremental investment requiredto purchase the new pipe networkNow($16,000)1Repairs in five years avoided5$5,0000.437$2,185Increased met annual cashinflows1-10$9,0004.494$40,000Salvage of the old network7,000Difference in salvage valuein 10 years10-0--NPV in favor of buying the newNetwork33,631
46The Ranking of Investment Projects When considering investment opportunities, managers must make two types of decisions:screening, andpreference decisions.Screening decisions pertain whether or not proposed investments are acceptable.Preference decisions come after screening decisions and attempt to rank selected projects in terms of preference.
47The Ranking of Investment Projects Internal rate of Return MethodWhen using IRR to rank competitive investment projects, the preference rule is: The higher the IRR, the more desirable the project.For example, an investment project with an IRR of 18% is preferable to another project that promises a return of only 15%.
48The Ranking of Investment Projects Net Present Value MethodIf the NPV method is used to rank projects, the NPV of one project cannot be compared directly to NPV of another project unless the investments in the projects are of equal size.
49The Ranking of Investment Projects –NPV Method Example 6InvestmentABInvestment required($80,000)($5,000)Present value of cash inflows81,0006,000Net present value$1,000
50The Ranking of Investment Projects –NPV Method Each project has a net present value of $1,000, but they are not equally desirable.The project requiring an investment of only $5,000 is much more desirable (especially when funds are limited) than the project requiring $However, there is a way to compare the two projects on a valid basis – its called Profitability Index.
51The Ranking of Investment Projects –NPV Method To calculate profitability index we need to divide the present value of all cash inflows by the investment required.The formula for profitability index is:Profitability index=Present value of cash inflowsInvestment required
52The Ranking of Investment Projects –NPV Method ABPresent value of cash inflows (a)$81,000$6,000Investment required (b)$80,000$5,000Profitability index (a)/(b)1.011.20
53Other Approaches to Capital Budgeting Decisions The Payback MethodThe Simple Rate of Return
54The Payback MethodThe payback method centers on a spam of time known as the payback period.The payback period is the length of time until the sum of an investment’s cash flows equals its cost.The payback period rule is to take a project if its payback is less than some prespecified number of years.The payback period is a flawed criterion, primarily because it ignores risk, the time value of money, and cash flows beyond the cutoff point.
55The Payback Method Example 7 GorVodokanal needs a new piece of equipment and considers two machines: machine A and Machine B.Machine A costs $15,000 and will reduce operating costs by $5,000 per year.Machine B costs $12,000 and will also reduce operating costs by $5,000 per yearWhich Machine should be purchased?
56The Payback Method Payback period = Investment Required Net annual cash inflowMachine A$15,0003.0 years$5,000Machine Bpayback period$12,0002.4 yearsGorVodokanal should purchase machine B, since it has a shorter payback period than A.
57Evaluation of the Payback Method The payback method is not a true measure of the profitability of an investment.Managers should not make investment decisions based on this method alone. Instead it should be used as a screening tool to determine which projects are worth further consideration.
58Evaluation of the Payback Method Payback method does not take into account differences between useful lives between investments.Furthermore, payback method does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow received today.