Capital Budgeting

FIN 591: Financial Fundamentals/ValuationSlide 2 Typical Capital Budgeting System

FIN 591: Financial Fundamentals/ValuationSlide 3 Illustration of Sustainable Growth

FIN 591: Financial Fundamentals/ValuationSlide 4 Calculating Accounting Rate of Return

FIN 591: Financial Fundamentals/ValuationSlide 5 Calculating Payback Period

FIN 591: Financial Fundamentals/ValuationSlide 6 Calculating Discounted Payback Period

FIN 591: Financial Fundamentals/ValuationSlide 7 Calculating NPV

FIN 591: Financial Fundamentals/ValuationSlide 8 Calculating NPV…

FIN 591: Financial Fundamentals/ValuationSlide 9 Use Nominal or Real WACC? Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment Common in capital budgeting is the use of market rates of return at the time of the analysis Market interest rates have embedded an assumption about inflation Use nominal cash flows to reflect the same inflation rate as that embedded in discount rate.

FIN 591: Financial Fundamentals/ValuationSlide 10 Risk-Return Tradeoff for Projects Projects plotting above the security market line (SML) have rates of return in excess of their required market rates Positive NPVs Projects plotting below the SML have rates of return less than their required market rates Negative NPVs Projects plotting on the SML earn their market rates Zero NPVs.

FIN 591: Financial Fundamentals/ValuationSlide 11 Calculating IRR

FIN 591: Financial Fundamentals/ValuationSlide 12 Illustration for Calculating IRR

FIN 591: Financial Fundamentals/ValuationSlide 13 IRR & Required Risk- Adjusted Rate Appropriate rates for comparing project returns are those falling on the upward sloping market risk- return trade-off curve Not the firm’s horizontal cost of capital line, WACC WACC is only appropriate for evaluating projects with risk comparable to the level of risk of the firm “Carbon copy” projects.

FIN 591: Financial Fundamentals/ValuationSlide 14 Size Problem

FIN 591: Financial Fundamentals/ValuationSlide 15 Cash Flow Pattern Problems

FIN 591: Financial Fundamentals/ValuationSlide 16 Multiple IRR Solutions

FIN 591: Financial Fundamentals/ValuationSlide 17 Undervaluation of Later Cash Flows

FIN 591: Financial Fundamentals/ValuationSlide 18 Calculating the Profitability Index

FIN 591: Financial Fundamentals/ValuationSlide 19 Comparison of Project Rankings Project B is better than project A Project B continues to earn cash flows longer Project D is more desirable than project C Although both projects generate the same amount of cash flows, project D does it earlier Unanswered question: Is Project D better than project B?

FIN 591: Financial Fundamentals/ValuationSlide 20 Sunk Costs

FIN 591: Financial Fundamentals/ValuationSlide 21 Salvage Value Comparisons

FIN 591: Financial Fundamentals/ValuationSlide 22 Calculating Initial Investment

FIN 591: Financial Fundamentals/ValuationSlide 23 Calculating Annual Operating Cash Flows

FIN 591: Financial Fundamentals/ValuationSlide 24 Alternatively, Calculating Annual Operating Cash Flows…

FIN 591: Financial Fundamentals/ValuationSlide 25 Calculating Terminal Cash Flows

FIN 591: Financial Fundamentals/ValuationSlide 26 Salvage Value: Present vs. Future

FIN 591: Financial Fundamentals/ValuationSlide 27 Another Topic: Competing Projects Assume projects Mutually exclusive On-going Different economic lives How do you select the correct project?

FIN 591: Financial Fundamentals/ValuationSlide 28 Example There are times when application of the NPV rule can lead to the wrong decision Consider a factory which must have an air cleaner The equipment is mandated by law, so there is no “doing without” There are two choices: The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years The “cheaper cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years Which one should we choose?

FIN 591: Financial Fundamentals/ValuationSlide 29 Example … At first glance, the cheap cleaner has the “better” NPV (r = 10%):  Overlooks the fact that the Cadillac cleaner lasts twice as long  When we incorporate project life, the Cadillac cleaner is actually cheaper.

FIN 591: Financial Fundamentals/ValuationSlide 30 Example … The Cadillac cleaner time line of cash flows: -$4,000 – $1,000 – ,  The “cheaper cleaner” time line of cash flows over ten years:

FIN 591: Financial Fundamentals/ValuationSlide 31 Investments of Unequal Lives Replacement Chain Repeat the projects forever, find the PV of that perpetuity Assumption: Both projects can and will be repeated Matching Cycle Repeat projects until they begin and end at the same time— like we just did with the air cleaners Compute NPV for the “repeated projects” The Equivalent Annual Annuity (EAA) Method.

FIN 591: Financial Fundamentals/ValuationSlide 32 Equivalent Annual Cost Method Equivalent Annual Annuity Method Provides the value of the level payment annuity that has the same PV as the original set of cash flows NPV = EAA × A r T For example, the EAA for the Cadillac air cleaner is $ The EAA for the cheaper air cleaner is $763.80, which confirms our earlier decision to reject it. Annuity Table 10%, 10 years =

FIN 591: Financial Fundamentals/ValuationSlide 33 Another Example: Calculating EAA

FIN 591: Financial Fundamentals/ValuationSlide 34 Human Face of Capital Budgeting NPV of a project  based on assumptions Managers must be aware of optimistic bias in these assumptions made by supporters of the project Companies need control measures to remove bias Analysis done by a group independent of individual or group proposing the project Analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential Another side of determining which projects receive funding – storytelling Best analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense.

FIN 591: Financial Fundamentals/ValuationSlide 35 The End