Ch.11 Capital Budgeting 1. Goals: 1) After tax cash flow 2) Capital budgeting decision techniques 3) “Solver” to determine the firm’s optimal capital budgeting

2. Estimating Cash Flows Before we determine whether an investment will increase shareholder wealth or not, we need to estimate the cash flows that it will generate. 2-1) Characters of Cash flows The cash flows should be total cash flows, taking account of cash in and out flows

It should be after tax cash flow It should not include sunk costs (sunk costs: cash flows that have occurred in the past and can’t be recovered - nothing to do with valuation) Financing costs should be excluded, because the discount rate will take account of these financing costs.

2-2)Three types of cash flows 2-2-1) Initial Outlay: net costs of project ex) IO = price of project+ shipping + installation+ training-(salvage-additional tax) + increase in net working capital 2-2-2) Annual after-tax cash flows = Additional Revenue + Costs Savings + Additional Expenses + Additional Depreciation Benefits

2-2-3) Terminal Cash Flows = (Recovery of NWC - Shutdown Expenses)*(1- marginal tax rate)+ Salvage- Salvage Taxes 2-4) An Example : Estimating the Cash Flows Depreciation: SLN(cost, salvage, life)

3. Making decisions 1) Payback Methods: To answer the question “ how long will it take to recoup our initial investment?” Rule: if payback period is longer than acceptable, the project is rejected. Ex) 3-1. Problem: - To ignore time value of money - To ignore all cash flows beyond the payback period

3-2) Discounted Payback Period Remedy one of problems in payback period rules: time value of money To calculate numbers of periods, use discounted cash flows. Rule: if payback period is longer than acceptable, the project is rejected. Discounted payback is always longer than regular payback Ex 3-2) Still ignore cash flows beyond the period where payback is achieved

3-3) Net Present Value (NPV) It represents the excess value captured by purchasing an asset. Rule: accepted if NPV > 0 It will shows how much shareholders’ wealth will increase

Built-in function-NPV- doesn’t calculate the NPV as we defined. It simply calculate the sum of present values of the cash flows. 3-4) Profitability Index It reports the dollar increase in shareholder wealth.

Rule: if PI > 1, projects are acceptable. EX) Scale Issues 3-5) Internal Rate of Return It provides a measure of the average annual rate of return IRR is the discount rate making the NPV equal to zero.

No closed form solution and have to use trial and error approaches. Built-in function, IRR(Values, Guess) (Here, values is contiguous range of cash flows and Guess is the initial guessing value) Ex) Problems of IRR: (1) Mutually Exclusive Projects: accepting one will preclude the other.

NPV will lead to different answers from IRR. This is caused by two reasons: different size and timing of cash flows. (1-1) Size problem: 100% return on a $10 investment and 10% return on $1000. (1-2) Timing of cash flows Ex) IRR calculation with non-conventional cash flow will lead to two IRRs

3-6) Modified Internal Rate of Return We want to use this built-in function, if compounding rate is changed. Ex) MIRR( Values, Finance_Rate, Reinvest_Rate). (here, Finance_Rate is a required rate of return and Reinvest_Rate is reinvesting rate)

3-7) Optimal Capital Budget To maximize shareholder wealth and use IRR or NPV. Relationship between IRR and WACC As long as projects generate positive NPV, accept the projects. How to use “Solver” to make a decision about the project portfolio. Tool > Solver Ex)