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1 CAPITAL BUDGETING What it is Large investment in plant or equipment with returns over a period of time. Investment may take place over a period of time A Strategic Investment Decision

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2 CAPITAL BUDGETING Purpose Expansion Improvement Replacement R & D

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3 CAPITAL BUDGETING What do we need to think about? Location Infrastructure Labour Cash Flows What is the most important?

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4 OVERALL AIM To maximise shareholders wealth.. Projects should give a return over and above the marginal weighted average cost of capital. Projects can be; Mutually exclusive Independent Contingent Process of Choice

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5 IDEAL SELECTION METHOD Will Select the project that maximises shareholders wealth Consider all cash flows Discount the cash flows at the appropriate market determined opportunity cost of capital Will allow managers to consider each project independently from all others

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6 SELECTION METHODS Payback RoA or RoI Net Present Value (NPV) Internal Rate of Return (IRR)

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7 CHOICE PAYBACK Project A Project B Yr 0 - 1,000,000 - 1,000,000 Yr 1 + 1,100,000 + 500,000 Yr 2 + 200,000 + 500,000 Yr 3 - 100,000 + 500,000 Project A = Year.909 Project B = ?

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8 PAYBACK Problems:- Ignores overall return Ignores impact of large flows Ignores timing of flows

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9 RoA Project A Project B Yr 0 - 1,000,000 - 1,000,000 Yr 1 + 1,100,000 + 500,000 Yr 2 + 200,000 + 500,000 Yr 3 - 100,000 + 500,000 n RoA Project A= Σ ( cashflows) ÷ Io t=o n (200,000) = 66,666.66 ÷ 1,000,000 =.0666 or 6.67% 3 Project B? Problems?

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10 NET PRESENT VALUE PROJECT A YrCF PV Factor @ 14% Present Value 0 - 1,000,0001.000 - 1,000,000 1 500,000.8772 438,600 2 500,000.7695 384,750 3 500,000.6750 337,500 4 500,000.5921 296,050 5 - 500,000.5194 - 259,700 NPV 197,200

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11 NET PRESENT VALUE PROJECT B - 1,000,000 900,000 200,000 100,000

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12 NET PRESENT VALUE PROJECT B - 1,000,000 - 1,000,000 900,000 789,480 200,000 153,900 200,000 135,000 100,000 59,210 100,000 51,940 NPV 189,530 Which project should we undertake? Why?

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13 Internal Rate of Return Project A Yr CF PVF@ 26% PV PVF@ 27% 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 500,000.793651 = 396,825.787401 393,701 2 500,000.629881 = 314,941.620001 310,000 3 500,000.499906 = 249,953.488190 244,095 4 500,000.396751 = 198,376.384401 192,200 5 - 500,000.314881 = - 157,441.302678 -151,339 2,654 -11,343 Interpolation IRR = 26.19% Project B 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 900,000 = 714,286 708,661 2 200,000 = 125,976 124,002 3 200,000 = 99,981 97,638 4 100,000 = 39,675 38,440 5 100,000 = 31,488 30,268 IRR = 27% 11,406- 991

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14 Interpolation 26%27% +2,654 -11,343 Q. Where on the line does 0 fall? From + 2654 0 = 2654 =.1896 or 18.96% of distance 13997 Since distance = 27-26 = 1% =.1896 of 1% Answer = 26 +.1896 = 26.19% 13,997

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15 Test @ 26.19% YrCFPVIFPV 0- 1,000,0001.0000 -1,000,000 1 500,000.7924558396,228 2 500,000.6279862 313,993 3 500,000.4976513248,826 4 500,000.3943667197,183 5 - 500,000.3125182 - 156,259 - 29

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16 Comparison of NPV vs. IRR 1. NPV accepts all projects with NPV > 0. Ranking of projects is by value of NPV. 2. IRR finds the value of the discount rate that makes NPV = 0. Project will be accepted if IRR > k (cost of capital) The big Q? Will the two methods always give the same answer? No, unfortunately not

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17 The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million. Capital Investment Decision

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18 YrCFPV@10%PV@20% 1 400363.6 333.3 2 400330.4 277.76 3 - 1,000 - 751.0 - 578.70 - 57 32.4 IRR = 15.8%

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19 Reinvestment Rate Assumption Project Yr0 Yr1 Yr2 Yr3 C of K NPV IRR X -10,000 5,000 5,000 5,000 10% 2,430 23.4% Y -10,000 0 0 17,280 10% 2,977 20.0% Illustration Reinvestment @23.4%End Yr 1End Yr 2End Yr 3 5,0006,1707,613 5,0006,170 5,000 18,783 @ 10% 5,0005,5006,050 5,0005,500 5,000 16,550

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20 Value Additivity ProjectNPV @10%IRR% 1354134.5 2104125.0 3309350.0 1 + 3663212.8 2 + 3413237.5

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21 Multiple Rates of Return NPV 400 200 IRR 15% Discount Rate 0 IRR – 12% -200 -400

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22 NPV Vs IRR Conclusion NPV is the correct method to use But - there are some additional issues

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23 Other Issues Scale How do we evaluate between projects of different scale? Project Outlay PV @ 10 % NPV A - 400 572 172 B - 500 683 183 How do we compare? If we have plenty of capital then it is not a problem. Both have a positive NPV so do both.

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24 Other Issues Scale Suppose we only have 600 worth of capital. Which project should we take? Work out the Profitability Index Present Value = PI Cost Project A = 572 = 1.43 400 Project B = 683 = 1.37 500

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25 Other Issues Scale Now work out the weighted PI For A (1.43 x 400) + (1 x 200) = 1.2866 600 600.9533.3333 For B (1.37 x 500) + (1 x 100) = 1.3084 600 600 Therefore take Project B

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26 Other Issues Project Lives What if projects take place over different time scales? Yr Project A Project B 0 - 17,500 -17,500 1 10,500 7,000 2 10,500 7,000 3 8,313 NPV @ 10% 723 894

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27 Other Issues Project Lives How to choose Assume you are able to repeat the projects until they have the same end date 0 2 4 6 A 3 B 723 597 723 (discount at 10%) 493 723 (discount at 10%) 1813

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28 Project Lives 0 2 4 6 3 894 672 894 (discount at 10%) 1566 Project B

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29 Project Lives This approach is fine for simple project lives but what if they are complex? E.g.lives of 7 years, 9 years and 13 years Answer make them all last for ever! NPV (n, to inf) = NPV n (1+ k) n (1+ k) n – 1

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30 Project Lives E.g. NPV 2 to inf = 723 (1.1) 2 = 723 x 1.21 (1.1) 2 - 1.21 723 x 5.76 = 4,165 NPV 3 to inf = 894 (1.1) 3 = 894 x 1.331 (1.1) 3 – 1.331 894 x 4.02 = 3,596

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31 Cash Flows Example – Consider the following new project:- Initial capital investment of £15m. It will generate sales for 5 years. Variable Costs equal 70% of sales. Fixed cost of project =£200,000 P.A. A feasibility study, cost £5,000 has already been carried out. Discount rate = 12%. Should we take the project?

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32 Cash Flows

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33 Cash Flows Treatment of depreciation in NPV analysis. -We only use cashflows in investment appraisal. -Depreciation is not a cashflow. -However, depreciation (capital allowances) is allowable against tax (see income statement), which affects cashflow. For cashflow, add depreciation back:-

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34 Treatment of Depreciation

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35 Issues to Consider Cash Flows But not in detail! Cash flows should be incremental - include all incidental effects (redundancy) - Do not forget working capital - Do forget sunk costs! - Be careful with allocated overheads

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36 Issues to Consider Cash Flows Uncertainty means more things can happen than will happen Brealy and Myers. How do we obtain a feel for what the cash flows are most likely to be? - Sensitivity Analysis - Scenario Analysis - Break Even Analysis - Simulation

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37 Issues to Consider Cash Flows Sensitivity Analysis Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet

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38 Issues to Consider Cash FlowsSensitivity Figure 7.1 HomeNets NPV Under Best- and Worst-Case Parameter Assumptions Green bars show the change in NPV under the best-case assumption for each parameter; red bars show the change under the worst-case assumption. Also shown are the break- even levels for each parameter. Under the initial assumptions, HomeNets NPV is $5.0 million.

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39 Issues to Consider Cash Flows Scenario Analysis Table 7.10 Scenario Analysis of Alternative Pricing Strategies

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40 Figure 7.2 Price and Volume Combinations for HomeNet with Equivalent NPV Capital Investment Decision The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher NPV and are superior.

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41 Issues to Consider Cash Flows Break even analysis Using the IRR to give a feel for the margin of safety ref the cost of capital

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42 Issues to Consider Discount Rate We also need to consider what discount rate to use as this will also effect the outcome. This is the next subject

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