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International Center For Environmental Finance. Environmental Finance Policy Presentation #?: Capital Budgeting Decisions

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CAPITAL BUDGETING Capital 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.

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Typical Capital Budgeting Decisions 1.Cost reduction decisions. Should new equipment be purchased to reduce costs? 2.Expansion decisions. Should a new plant, warehouse, or other facility be acquired or built to increase capacity and sales? 3.Equipment selection decisions. Which of several available machines would be the most cost effective purchase? 4.Lease or buy decisions. Should new equipment be leased or purchased ? 5.Equipment replacement decisions. Should old equipment be replaced now or later?

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Discounted Cash Flow There are two approaches to making capital budgeting decisions by means of discounted cash flow. 1.The net present value 2.The internal rate of return

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The 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.

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The Net Present Value Method Example 1 Moscow 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?

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The 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=$50,000 However, it is not that obvious. To see if this investment is acceptable we have to perform Net Present Value Analysis

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The 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.

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The Net Present Value Method Time (years) Initial cost($30) Inflow$20 Outflow-14 Net inflow$6 Salvage2 Net cash flow($30)$6 $8

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The Net Present Value Method Present Value = $6,000x[1-(1/ )/ (2,000/ )=($6,000 x )+ +(2,000/3.0590)=$26, = =$27,578 When we compare this to the $30,000 estimated cost,we se that the NPV is: NPV=-$30, ,578 = -$2,422 Therefore, this is not a good investment

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The 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

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The Net Present Value Method Summary: If the Net Present Value Is …Then the Project Is… Positive Acceptable, since it promises a return grater than the required rate of return Zero Acceptable, since it promises a return equal the required rate of return Negative Not acceptable, since it promises a return less than the required rate of return

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The Net Present Value Method Example 2 Now 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?

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The 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) + (2,000/1.1 2 ) + + (4,000/1.1 3 ) + (4,000/1.1 4 ) + (5,000/1.1 5 )= = $1, , , , ,105 = = $12,313 NPV = $12,313 – 10,000 - $2,313

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Importance 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.

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Cash Outflows Most 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.

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Cash Outflows Cash Outflows: Initial investment Increased working capital needs Repairs and maintenance Incremental operating costs

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Cash Inflows Any 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.

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Cash Inflows Cash Inflows: Incremental revenues Reduction in costs. Salvage value Release of working capital

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Choosing 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.

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Extended Example of the NPV Method Example 3 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:

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Extended Example of the NPV Method Cost of equipment needed$60,000 Working capital needed100,000 Overhaul of the equipment in four years5,000 Salvage value of the equipment in five years10,000 Annual revenue and costs: Sales revenues200,000 Cost of goods sold125,000 Out of pocket operating costs (for salaries, advertising, and other direct costs)35,000

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Extended 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?

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Extended Example of the NPV Method Sales revenue$200,000 Less cost of goods sold125,000 Less out-of-pocket costs for salaries, advertising, etc.35,000 Annual net cash inflows$40,000

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Extended Example of the NPV Method ItemYear(s) Amount of Cash Flows 20% Factor Present Value of Cash Flows Purchase of equipmentNow($60,000)1 Working capital neededNow-100,0001 Overhaul of equipment4-5, *-2,410 Annual net cash inflows from sales of the product Line , ^119,640 Salvage value of the equipment510, *4,020 Working capital released5100, *40,200 Net present value $1,450

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Extended Example of the NPV Method *From Present Value and ^Present Value of an Annuity Tables Notice 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.

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Discounted Cash Flows –The Internal Rate of Return Method

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The 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.

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The Internal Rate of Return Method Example 4 GorVodokanal 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

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The Internal Rate of Return Method Initial cost$16,950 Life of the project (years)10 Annual cost savings$3,000 Salvage value0

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The 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 = $16,950 =5.65 Net annual cash inflow $3,000

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The 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 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.

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Present Value of an Annuity Table Period4%5%6%8%10% 12% 14%

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The 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

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The Internal Rate of Return Method ItemYear(s) Amount of Cash Flows 12% Factor Present Value of Cash Flows Annual cost savings1-10$3,000 5,650*$16,950 Initial investmentNow-16,9501,000-16,950 Net present value $0

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The 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.

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The NPV of Return Method The NPV method can be used to compare competing investment projects in two ways. 1.total-cost approach 2. incremental-cost approach

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The Total Cost Approach Example 5 GorVodokanal 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

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The 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.

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The Total Cost Approach New Pipe Network Old Pipe Network Annual revenues $40,000 Annual cash operating costs 21,00030,000 Net annual cash inflows $19,000$10,000

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The Total Cost Approach ItemYear(s) Amount of Cash Flows 18% Factor* PV of Cash Flows Buy the new pipe network: Initial investment Now($36,000)1.000($36,000) Repairs in 5 years5($3,000)0.437($1,311) Net annual cash inflows1-1019, ,386 Salvage of the old network Now7, ,000 Salvage of the new network106, ,146 Net present value$56,221

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The Total Cost Approach ItemYear(s) Amount of Cash Flows 18% Factor* PV of Cash Flows Keep the old pipe network: Initial repairs Now($20,000)1.000($20,000) Repairs in five years5($8,000)0.437($3,494) Net annual cash inflows1-1010, ,940 Salvage of the old network106, ,146 Net present value$22,590

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The Total Cost Approach NPV of the New Pipe Network$56,221 NPV of the Old Pipe Network$22,590 NPV in favor of buying the New Network$33,631

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The 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.

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The Incremental Cost Approach ItemYear(s) Amount of Cash Flows 18% Factor * PV of Cash Flows Incremental investment required to purchase the new pipe network Now($16,000)1 Repairs in five years avoided5$5, $2,185 Increased met annual cash inflows1-10$9, $40,000 Salvage of the old network Now7,0001 Difference in salvage value in 10 years NPV in favor of buying the new Network33,631

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The Ranking of Investment Projects When considering investment opportunities, managers must make two types of decisions: 1.screening, and 2.preference 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.

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The Ranking of Investment Projects Internal rate of Return Method When 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%.

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The Ranking of Investment Projects Net Present Value Method If 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.

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The Ranking of Investment Projects –NPV Method Example 6 Investment A B Investment required($80,000)($5,000) Present value of cash inflows81,0006,000 Net present value$1,000

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The 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.

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The 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 inflows Investment required

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The Ranking of Investment Projects –NPV Method Investment AB Present value of cash inflows (a)$81,000$6,000 Investment required (b)$80,000$5,000 Profitability index (a)/(b)

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Other Approaches to Capital Budgeting Decisions 1.The Payback Method 2.The Simple Rate of Return

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The Payback Method The 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.

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The 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 year Which Machine should be purchased?

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The Payback Method Payback period= Investment Required Net annual cash inflow Machine A Payback period = $15,000 =3.0 years $5,000 Machine B payback period = $12,000 =2.4 years $5,000 GorVodokanal should purchase machine B, since it has a shorter payback period than A.

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Evaluation 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.

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Evaluation 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.

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