capital budget 2

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Capital Budgeting Process 9-

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Capital Budgeting Process 9-Capital Budgeting Process 9-

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Chapter 9

CAPITAL

BUDGETING


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PROCESS


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1 . I N T R O D U C T I O N

# Working with the left-hand-side of a balance sheet

# CAPITAL BUDGETING /INVESTING in Long-term Assets !Definitions

" Capital: Fixed assets used in production

" Budget: Plan of in- and outflows during some period

" Capital Budget: A list of planned investment (i.e.,expenditures on fixed assets)outlays for different projects.

" Capital Budgeting: Process of selecting viableinvestment projects.

" Financial investment vs. economic investment

! In this course, investments are needed in order to:

" Expand in existing markets.

" Enter new markets.

" Replace existing capital assets.


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! Where do these projects come from?

" Suggested by managers of plants & divisions "

Upper management

! Upper management approves these projects

! Investment and financing decisions are independent.

! Some common errors:" Expansion without incorporating cost of financing" Cost cutting without looking at revenue side" Ignoring alternative uses of capital

# TOOLS CAN BE USED IN:

! M&As

! Divestitures & spin-offs

! Correct-sizing

! Other


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# CAPITAL BUDGETING OUTLINE

! Develop tools & criteria of selecting projects (Ch. 8): Given Q

Relevant CFsQ The required return of the project (i.e., the risk of use of

project CFs)

! Determine which CFs are relevant in project analysis (Ch. 10)

! Introduce possibility of forecast error in CF data used inanalysis (Chapter 11)

! Assume that k (cost of financing) is known until Ch. 12


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Type of Business

Choose AppropriateFinancing

Choose AppropriateWorking capital

FINANCIAL MANAGEMENT

PROCESS

Given yourLine of Business

List Potential

Projects

Type of

ProjectsInternal

Expansion

External

(M&A)

Divestitures

& Spin Offs

Capital Budgeting

Capital Structure

Short-term financialManagement

Dividend Policy

Choose Viable

Projects

OptimalDividend polic


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INVESTMENT

DECISION

CAPITAL BUDGETING &

FINANCING


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MANAGERIAL TALENT &

IN VESTMENTS


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2 . T O O L S O F I NVE S T M E NT DE S I RAB I L I T Y

2.1 BASIC INTUITION

1)Criteria

How fast you re-coup initial investment?Benefits > CostsCompare PV of cash inflows & PV of cash expenditureCompare return on investment & cost of financing project

2)A word of Caution

A manager needs to make a decision today (t=0) givenestimated/forecasted cash flows. Obviously there is noguarantee that the decision would always turn out asanticipated. However, what is important is that the managerhas to make the best decision at t=0 given all the relevantinformation.

2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS:# Independent: A project that has nothing to do with

other projectsunder investigation.

Example : Replace copy machine andbuild a new plant.

# Mutually Exclusive: You only need one ofthese alternative

projects.

Example : Buy IBM or Apple PC?


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2.3 TOOLS

3.1 Payback Period Method:

Criterion: For two mutually exclusive projects, choose the one thatpays you back your initial cost the sooner.

Example: Calculating Payback Period

Given the following CFs, and k = 10%, we get:

Investment Initial cost CF1 CF2

A $10,000 0 $14,400

B 10,000 $10,000 2,400

choose project B, since it pays back initial investment in one

year.

? Is this choice optimal?


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NPV ' PV of all Relevent CFs & Initial Investment

CF1 CF2 CFn% % ...%

(1%k)1 (1%k)2 (1%k)n

n CFt'j & I0t'1 (1%k)t

n CFt

' CF1 [PVIFk,1 ] % CF2 [PVIFk,2 ] % ... % CFn [PVIFk,n ] & I 0

'j (1t'0 %k)t

3.2 Net Present Value (NPV) method:

L Payback ignores the concept of CFs. Ignores CF after payback andrisk of CFs.

we need to look at the PV of these CFs net of any initial cost.

where,CFt

I0k

/Net cash flow (inflow - outflow) at time t/ Initial cost or investment outlays/ cost of capital (financing)/ required return reflecting risk of use ofCFs

Note: CF0/ I0


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Thus,

NPV measures the additional market value thatmanagement expects the project to create (or destroy) ifit is undertaken.

NPV Criteria:

Since the objective of the manager is to maximize value, then for

Independent Projects : Choose All Projects with NPV > 0.

Mutually Exclusive: Choose projects with the highest

NPV.

Note: NPV > 0 is equivalent to PV of cash inflow > PV of cashoutflow.


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Example: Calculating NPV

Given the following CFs, and k = 10%, we get:

Investment Initial cost CF1 CF2

A $10,000 0 $14,400

B 10,000 $10,000 2,400

Solution:

NP VA '

NPVB '

$14,400 & 10,000 ' $1,901(1%k)2

10,000 2,400%_______________&10,000 ' $1,074

(1 %.1)1 (1 %.1)2

choose A, since it has the highest NPV if mutually exclusive,or both if independent as they are both with NPV >0.


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Remarks on payback method:

With payback method, project B is selected. Thus, if you ignore

amount, timing, and risk of CFs, then potentially you would end upwith the wrong valuation.

Both projects would add value to shareholders. However, if youselect project "B", you would not be maximizing shareholder value,as "A" provides more value to shareholders.

In general, if you accept a project with NPV


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Value created per share '

Example: Calculating additional Shareholder Value

Using a project's NPV = $1,901 and assuming that there are 1,000 sharesoutstanding, then

NPV

# of shares outstanding

$1,901'________ ' $1.901

1,000

If the project is adopted then the price of the stock should increase by$1.90.


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3.3 Internal Rate of Return Method (IRR)

# Motivation:! Internal in that it is a rate of return that depends on the CFs

of the project.

! Return on investment (ROI) is a very intuitively appealingconcept; measured in % terms.

ROI ' profit

investment

! Easy to determine profit if you have single CF in future. Whatabout if we have multi-period payoffs?

Periods

0 1 2 3

CF from project -100 10 60 80

Profit would be calculated as:Ending Value - Beginning Value = $80 - $100

But this calculation ignores the intermediate CFs, namely $10and $60 in periods 1 and 2 respectively.


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CF 1 % CF2 % ...% CFN

(1 % IRR) (1 % IRR)2 (1 % IRR)NNPV' 0 ' CF0%

Thus, when examining the return on a project, we need anew tool that would incorporate all the cash flows of a

project.

# Definition of IRR : IRR is defined as that particular k, such that theproject breaks-even, i.e., when NPV = 0.Thus,

Decision Rule:

IRR Criterion: Choose projects with IRRhigher than cost offinancing.

L If [the cost of financing "k"] < IRR NPV > 0 Additional value would becreated. Obviously the larger the difference between k & IRR, thehigher the NPV.

Note: Use IRRcautiously for mutually exclusive projects!Limitations of IRR are discussed on p. 21.


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Example: Calculating IRR (single future CF)

Given:

Period CF($)

0 -100

1 300

Solution:

300 &100%________________' 0

(1 %IRR)

300 ____ ' 100

(1 %IRR)

100(1%IRR) ' 300

100 % 100IRR ' 300

300&100 200IRR '____________' ' 2 ' 200%

100 100

The ROI is:

ROI '$300 & $100 ' 200% $100


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Example: Calculating IRR (multiple future CFs)

Given:

Periods

0 1 2 3

CF from project F -100 10 60 80

IRRF = ?


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.. .

CFN%

' 0(1 %IRR)N

Try a smaller #, say IRR =

>0

Solution:

L To calculate IRR (just like YTM) there is no simple formula to use.Thus, we need to use either trial & error method or a calculator.From definition of IRR,

______________CF ____________1 CF 2

CF0%___________ %__________ %

(1%IRR) (1%IRR)2

Guess an IRR, say IRR = 19%, then substituting in above equation

yields:

10 60

&100%________%__________

80%_________

< 0

You have guessed a number too high. 17%, thus

10 60 80&100%___________%__________ %_________

(1%.17) (1%.17)2 (1%.17)3

If you try IRR = 18.1%, you get correct answer.

IRRF = 18.1 % (using either trial & error or calculator)


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NPV Flow Profile: Relation between NPV, IRR, and "k"


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Problems With IRR for Mutually Exclusive Projects:

Problem 1: Consider two projects such that returnA = 15%, returnB =

50%, and k = 10%. Which would you choose?

Now assume that they require the following initial investments:IA = $1,000,000 while IB = $100

? Which would you choose?

If initial investments are not equal, IRR ranking can be

misleading.

Problem 2: Possible existence of multiple IRRs. Every time the CFschange sign, you would get an additional IRR. (See NPV,IRR, "k" profile)

Problem 3: Possible conflict of ranking with NPV.


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% use of each Tool

Primary method NPV

IRR

payback

AROR Secondary method

NPV

IRR

payback

AROR

21% 49 19 8

24% 15 35 19

3.4 What tools does industry use?

AROR ' Accounting Rate of Return

j accounting profit after taxt/N

t'1

(initial outlays %salvage value)/2

where t is time, and N = # of periods

Source: Kim, Crick, and Kim, "Do executives Practice What Academics Preach?"Management Accounting (November 1986), pp. 49-52.


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So Why Does Industry Still use IRR Despite Problems?

percentage results are more intuitive than a $NPV; 50% return vs.NPV = $500,000

Since IRR gives you break-even cost of financing:The number itself is of interest to managers; you want simplyto ask at what financing cost does project break-even?

If a project's break-even is 100%, in a "normal" situation, you

wouldn't need to go through the trouble of estimating all the CFs, as100% is considerably higher than a normal financing rate.

? Why Do Managers Use Payback with All of its

Problems?


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3. SUMMARY

T Payback Period

T NPV

# Independent Projects

# Mutually exclusive

# NPV = sum of discounted CFs, where the discount rate isthe cost of financing the project.

# NPV criterion is equivalent to PV of cash inflow > PV ofcash outflow

T IRR

# Criterion

Two equivalent ways to look at itBreak-even or ROI > cost of financing project

# Calculation

! Trial & error !

Calculator


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4. QUESTIONS

I. True/Disagree-Explain

1. According to the NPV criterion, you should choose all projects with NPV > 0.

2. According to the IRR criterion, you should choose projects with IRR < cost of financing.

3. Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction.

4. Capital budgeting tools can be used to analyze the merits of "flextime."

5. A NPV > 0 project might not be undertaken because of its high risk, despite the manager'sconfidence in the accuracy of the CF estimates.

6. If a company is expanding, then it is necessarily creating additional value to shareholders.

7. If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor'sprofits would be zero.

II. Problems1) Given:

Project S Project L

Cost $10,000 25,000

Annual Benefits $4,000 8,000

# of years 5 5

k 14% 14%

Which of these mutually exclusive projects is better based on NPV and IRR?


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ANSWERS TO QUESTIONS I.

Agree/Disagree-Explain

1. Disagree. Only if the projects are independent. If they are mutually exclusive, then youchoose the one with the highest NPV.

2. Disagree. If IRR < cost of financing, then the project would be losing money as it costsmore to finance than to break-even. Such a project will have NPV < 0.

3. Agree. NPV = -market price + PV of dividends. Present value of a stock would be itsAgree worth--value. If you pay (market price) exactly its worth (PV of dividends), then NPV= 0.

4. Agree. Analyzing flextime corresponds to analyzing its impact on a firm's CFs. However,in practice it is difficult to obtain good estimates of the incremental CFs. Thus, if "flextime"makes sense, then you would be undertaking a NPV > 0 project.

5. Disagree. The risk of CFs is reflected in the cost of capital (k). Thus, the fact that youobtain a NPV > 0, and assuming you did the correct calculation, the project should beaccepted.

6. Disagree. Only if it is re-investing revenue at a rate higher than the required rate of return.A simple example would be a company borrowing to finance projects that are not profitable,NPV


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L

S

II. Problems

1)

Step 1 Are CFs of equal length? Yes

Step 2 Calculate NPV

NPVS

= -10,000 + 4,00 0(PVIFA14%,5)= 3,732 NPVL

= -25,000 + 8,000(PVIFA14%,5)= 2,465

Using IRR: IRRS

= 28.6% and IRRL

= 18%

Since cost of capital for each = 14% < IRR. Accept S as it has a higher IRR.Obviously, you should choose both if they were independent.


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ELIMINATIONS

a . APPRO ACH E S T O CAPI T AL B UDG E T I NG

Top Down Approach Bottom up Approach

I NT E R-DE PE NDE NCE O F I NVE S T M E NT &

FI NANCI NG DE CI S I O NS

I l l u s t ra t i o n 1 :

Project 1: ATT owes you $100, and makes you an offer of $100 today or

$107 next year. Which would you choose? Assume that returnon similar risky investments is 6%.

Project 2: Suppose, in addition to the ATT opportunity, you have a "greatdeal" that requires a $100 investment that is expected to payoff$300 in a year.

Case 1: Assume: you can borrow at a cost of 10%. Action: Take both

projects (independent)


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NPVA T T ' & 100 % 100.94 ' $.94

VA T T '$107 ' 100.94 > $100

(1 % .06)

choose $107 as

PVATT 1.06

NPV ' &100 % 300 ' $1 7 2 7

Thus, if you borrow, in effect you would be undertaking bothprojects.

Total NP Vindependent = NP VAT T + NP Vgreat deal

= 0.94 + 172.7 = 173.64

Case 2: You cannot borrow, or cost of borrowing is 400% andassume that a project with same risk as "great deal" hasa return of 12%.

Action: Mutually exclusive projects


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" "' &100 % 300

' &100 % 60 ' &40 < PVIRS


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NPV' & 100 %

1% .12

Obviously, in this case you are better off taking $100 from ATT. Thus,

Choose project with highest NPV choose "great deal".

Notes:! You discount at 12%, since it is the return you have to forego

if you invest in a project with same risk as ATT.NPVindependent > NPVmutually exclusive


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where ROE '

(RR) (EPS1) (ROE)

k

ROE.

( ( ( )

b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV

p0 = PV (CF of existing business) + NPV ( dividend growth due to

investment of future earnings)PS11

% NPVGO k

Let RR' Retention Ratio D1 ' (1&RR) (EPS1)

return on retained earnings ' (RR) (EPS1) (ROE) EPS1

book equity per share

NPV1 ' & I0% PV of increases CFsP

& (RR) (EPS1) %%

(RR) (EPS1)&1 %

NPV1, NPV2 ,.... are growing at a rate (RR) (ROE) ' g

______________NPV 1NPVGO '

k& g

EPS1

NPV1

D1

p0 '________ %__________ '_________k k& g k& g

Substitute NPVGO in (*), we get

Conclusions:NPVGO depends on a.EPS1: current earnings size


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0.Relative magnitudes of ROE and k; see equation (**) above.

a.Growth, (RR)(ROE), does not necessarily imply NPV .


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c. WHERE DO NPV> 0 PROJECTS COME FROM?

# In long-run NPV = 0 excess economic profit = 0

# Sources of NPV > 0 (Sources of competitive advantage)! Barriers to entry

product differentiationeconomies of scale

better distribution channelsluck

INVESTMENT UNDER UNCERTAINTY

Classical micro-economic theory

Observations:

# Firms use cost of capital "hurdle rate" in NPV > 3 times cost ofcapital firms invest only if price is substantially > LRAC(Summers '87)

# Firms stay in business even after p < AVC

. # First quarter of '85 $ started By end of '87, $ was at '78 level.But, import volume did not until 2 years later. (Krugman &Baldwin '87)


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# U.S. firms abandon project earlier than Japanese (TV, VCR, semi-conductors)

Explanation:

Agree NPV = NPV + flexibility option

Sources of option value:

# sunk costs in abandonment decision! Severance pay for workers (-)

! scarp value (+) (Myers & Majd '85)" capital used is industry specific (eg. steel mills) Who is going

to buy machinery when entire industry is suffering?!

" lemon problem" stop and re-start needs additional costs (McDonald &

Siegel '85)

# Uncertainty: product price, operating costs, interest ratesvalue in option to wait (Pindyck '91, Ross & Ingersoll '92)

! parameters:

" if uncertainly is high value of waiting" if k is low future outcomes valued more value of

. option to wait and resolve future uncertainty

" What happens if there are other firms in industry?"balance" between waiting and implementing(Fudenburg & Tirole '83, Stiglitz '89)

" if k does not Investment as cost of waiting" Why did U.S. abandon color TVs, VCRs and semi-

conductors?The value of waiting to invest is governed by downside risk. But Japanese

government supports


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firms during downside through cartelization toavoid destructive competition. (Bernake '83)

! Sequential investing , as in drug industry

# Remarks

! If 400% (in above illustration) is the cost of borrowing, maybethat is the Agree cost of financing.

If a project sounds "too good to be Agree," it probably is "toogood to be Agree."

Role of market in information processing vs. personalborrowing market.

capital budget 2

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