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
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• 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
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ATCF
PI
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• 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)