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

i i

i tsr

FCFNPV cos

)1(

• 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.

•

IO

PVCF

IOi

ATCF

PI

N

ttt

1 )1(

• 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)