1. Agenda
Capital Budgeting Decision Frameworks

2. Capital Budgeting Process
Goal of management is to maximize value
Companies continually invests in a portfolio of projects
In theory all projects that create value should be approved
In reality, a company may not invest in all projects estimated to create value
Capital budgeting is the process to assess:
if an investment will create value for the investors
Expected project return > cost of capital
If constrained, how to prioritize across investments.
Capital constraints
Non-Capital constraints
Estimation Bias
Describe process to create a budget
ZBB process
What would you like to see in approving a project

3. Capital Budgeting Process
Compliance with new Federal regulation
New Product
Upgrade the Factory
Capital Budgeting Process
Marketing Program
Approved Projects
Open new Sales office
Leadership Training
‘Big Data’ Software
New Feature for existing product

4. The Capital Budgeting Decision Process
The capital budgeting process involves a few basic steps:
Identifying potential investments
Ensure potential investments are linked to strategic direction
Types of Projects: Safety, Replacement, Contraction, Expansion (products or markets), Mergers
Reviewing, analyzing, and selecting from the proposals that have been generated
Strategic Alignment
Does the project create value?
Implementing and monitoring the proposals that have been selected
Analyzing involves valuing the project -> same principles as valuing a security or business

5. A capital budgeting process should…
Be easy to apply and explain
Focus on cash flow
Account for the time value of money
Account for project risk
Lead to investment decisions that maximize shareholders’ wealth

6. Investment Decision Frameworks
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index
Payback
Discounted Payback
All frameworks will require a financial forecast
Most require size of cash flows, timing of cash flows and risk.
Typical profile: investment in development, marketing, capital and inventory
revenue ramp and then transition down
costs to support and then reclaim of some investment
Does the profile make economic sense? Create value

7. What Companies Do Globally7

8. Project Analysis General Framework
What are the cash flows associated with the project
Understand the strategy and operational assumptions related to the project
Forecast the pro forma financials
Income statement and balance sheet
Percent of sales approach as starting point
Utilize ratios & competitive positioning to guide assumptions
Free Cash flow = CF from Operations - Investment in WC – Investment in LT Assets
Only new, incremental cash flows should be included
Assess riskiness of cash flows: Discount Rate
WACC: Cost of Equity (CAPM) and Cost of Debt (after tax yield)
Market based costs and Target or Market weights
Risk based on the project cash flows, not necessarily that of the company
Apply decision criteria (NPV, IRR, payback)
NPV generally the best method
Test the decision and the critical assumptions
What are the key inputs that have the most uncertainty?
What causes the decision to change?
Utilize Scenarios, Sensitivity, Breakeven to focus on key assumptions
Recommendation with key risks identified and suggestions to mitigate

9. Capital Budgeting Decision Frameworks
Net Present Value
Present Value of all future cash flows
Discount rate based on risk of project
Acceptance Criteria: NPV > $0
NPV Amount = amount of value creation
IRR / MIRR
Discount rate that results in NPV = 0
Cash flow forecast same as NPV analysis
Acceptance Criteria: IRR > Cost of Capital
Profitability Index
Present Value of Cash Inflow divided by
Present Value of Cash Outflow
Cash flow forecast same as NPV analysis
Acceptance Criteria: PI > 1.0
Payback
Numbers of time periods required to
recoup the investment
Cash flow forecast same as NPV analysis
Acceptance Criteria: Arbitrary

10. NPV Profile Project NPV NPV > $0 +$ IRR > Discount Rate $0-$
NPV > $0
IRR > Discount Rate
IRR of Project
Discount Rate
NPV < $0
IRR < Discount Rate

11. NPV versus IRR NPV and IRR will generally give the same decision.
Exceptions:
Mutually exclusive projects
Scale is substantially different
Timing of cash flows is substantially different
Non-conventional cash flows – cash flow signs change more than once
Modified IRR can help with the non conventional cash flows and re-investment rate assumptions
Profiles of non traditional CFs
Reinvest rate assumptions:
NPV= cost of capital
IRR= IRR
MIRR, define the reinvestment rate
MIRR

12. Example
Company is considering investing in a new product requiring $35M in R&D and $125M in capital equipment.
Total available market (TAM) size is 400M units / year. Company expects to address 15% of TAM and initially capture 2% market share.
Product price is $70 / unit
COGS is 40% of price
Sales and Marketing expense is estimated at 10% of revenue. General and administrative is 5% of revenue
Working capital is forecast as:
A/R at 10% of sales, Inventory at 15% of sales, A/P at 8% of sales
Depreciation based on 3 year MACRS
Tax rate is 35%
Product life is approx 4 years. Equipment will have a $10M salvage value
Cost of capital = 10%
Should the company invest in the new product?

13. Which Cash Flows -> Incremental Cash Flows
Cash flows matter—not accounting earnings.
Incremental cash flows matter.
Sunk costs do not matter.
Don’t forget start-up and salvage value cash flows
Opportunity costs matter.
Externalities like cannibalism and erosion matter.
Inflation matters.
Taxes matter: we want incremental after-tax cash flows.

14. Depreciation
Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes.
Accelerated depreciation methods such as the modified accelerated cost recovery system (MACRS) increase the present value of an investment’s tax benefits.
Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life.
Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements?
For capital budgeting analysis, it is the depreciation method for tax purposes that matters. 14

15. Assignments for Next Class
Investment Decisions and Risk Analysis Chapter 11

16. Summary – Investment Decision Frameworks
Net present value
Difference between market value and cost
Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually exclusive projects
MIRR can address the non-conventional cash flow issue
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Payback
Time required to recoup the initial investment
Does not account for timing, risk or cash flows beyond payback period
Payback decision criteria is arbitrary
NPV is preferred
Benefits of other methods -> provide insight on margin of safety
A B
NPV $10M $10.5M
IRR % %
Investment $5M $60M

17. Example A company has two potential projects to invest in:
Each has a cost of capital of 10%
What would you recommend?

18. Net Present Value Minimum Acceptance Criteria: Accept if NPV > 0
Net Present Value (NPV) = Total PV of cash inflows – PV of costs
Minimum Acceptance Criteria: Accept if NPV > 0
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project must earn to satisfy investors.
r varies with the risk of the firm and/or the risk of the project.

19. Internal Rate of Return
Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project.
IRR found by computer/calculator or manually by trial and error
The IRR decision rule is:
If IRR is greater than the cost of capital, accept the project.
If IRR is less than the cost of capital, reject the project.
Similar to a YTM calculation
Significance of IRR / NPV=0 ?

20. Pros and Cons of Using NPV as Decision Rule
NPV is the “gold standard” of investment decision rules.
NPV is the present value of cash inflows less present value of cash outflows
How much the project contributes to shareholder wealth
Key benefits of using NPV as decision rule
Focuses on cash flows, not accounting earnings
Makes appropriate adjustment for time value of money
Can properly account for risk differences between projects
Though best measure, NPV has some drawbacks.
Lacks the intuitive appeal of payback
Doesn’t capture managerial flexibility (option value) well 20

21. Pros and Cons of Payback Method
Advantages of payback method:
Computational simplicity
Easy to understand
Focus on cash flow
Disadvantages of payback method:
Does not account properly for time value of money
Does not account properly for risk
Cutoff period is arbitrary
Does not lead to value-maximizing decisions

22. The Profitability Index (PI)
Present Value of Future Cash Flows
Initial Investment
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Advantages:
Easy to understand and communicate
Correct decision when evaluating independent projects
Disadvantages:
Problems with mutually exclusive investments