math prblms

7/31/2019 Math Prblms

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Capital Budgeting

Economic concepts and finance

decision-making toolsBUS 219


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Building Blocks of Knowledge

Time value of money adollar in the future is worthless than a dollar in handnow

Net present value1. NPV = PV of cash flow

benefits Investment cost

2. Accept project if NPV > $0

Financial Statements

Cash is king


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What is this slide show about?

Ingtegrates topicsfrom several

chapters ofCorporate Finance

NPV

Discounted cash-

flow analysis Project analysis


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Capital Budgeting

Investment decisions involving capitalassets (tangible property, including

durable goods, equipment, buildings,installations, land)

Capital refers to the fixed assets of an

organization (factories, hospitals,schools, and their major equipment fitinto this category),


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Capital Budgeting (more)

A budget is a plan which explains theprojected cash flows during some future

period.A capital budget is therefore an outline of

planed expenditures on fixed assets, andcapital budgeting is the whole process of

analyzing projects and deciding whetherthey should be included in the capitalbudget


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Capital Budgeting - Public Sector

Capital budgeting is done in the public sectortoo, although it is not always referred to as

such. Economic analysisand investment analysis

are synonymous terms that one my hear.

Benefit-cost analysisand cost-effectivenessanalysis play an important role in the processof capital budgeting


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Capital budgeting decisions

are among the most

important ones made bymanagers and executives.


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Importance

Results of investments in schools andhospitals continue for many years.

Once these decisions are made, theorganization loses some of its flexibility.

Once a major piece of equipment is

purchased, the organization is lockedin to using it for the long term.


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Importance (more)

Errors in the forecast need for big ticketassets can have serious consequences(LILCO-Shoreham)

Imagine an office or hospital being built, or aschool established, and then there is notenough demand to utilize the services.

Conversely, what happens if not enough isspent. Inadequate capacity in a business,hospital or school can have disastrousresults.


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Importance (even more)

Timing is anotther reason that good capitalbudgeting is so essential.

Essential assets need to be ready to come on-line when needed. Early arrivals cause extraexpenses that will strain resources.

Funding of such major projects involves verysubstantial expenditures. Large amounts of

money are not available instantaneously in anyorganization, be it a large corporation, school

district or the federal government.


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Capital budgeting has become more

effective, and more fun, during the past

decade Used to be math and manpower intensive,

because the underlying theory needs a lot ofcalculations

Nowadays, most modern organizations areable to use computers to transform data toinformation

Capital budgeting used to take man years ofwork, mostly in manual calculations. Nowcapital budgeting is done in hours withspreadsheets


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What was once a budgetexercise becomes an

analysis of policy (PeterDrucker)


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Steps in the Capital Budgeting

Process1. Determine the economic life of the

project or alternatives you are

considering.2. Estimate theirIncremental Cash Flows

3. Determine the discount rate.

4. Calculate Net Present Value5. Apply the appropriate criterion to arrive

at an initial preference


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More Steps in the Capital

Budgeting Process6. Do Sensitivity & Scenario Analysis

7. Interpret the results of the basic analysis

and the sensitivity/scenario analysis, andmake a decision.

8. If you decide to aquire the use of anasset, evaluate: lease versus buy

9. Check to make sure you can afford yourdecision by putting it in the organizationsbudget.

10. Implement & Verify your decision.


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Capital Budgeting Decision

making Concepts you must

understand to be able toparticipate: incremental cash flows

the time value of moneyand sensitivity analysis


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Incremental Cash Flows

Two RulesAnnual cash flow, and not accounting

profits or costs, are to be used.

Depreciationand the need forWorkingCapitalare causes of major differencesbetween profits and cash flow

Only Incremental cash flowsare relevant

for evaluating investment projects. Onlythose cash flows that would result directlyfrom a decision to accept a project areconsidered


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Working Capital

The payroll needs to be paid beforerevenues from the days work are

received Working capital is the cash you need to

pay expenses before the benefits are

realized


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Taxes and Depreciation

Taxes are a fact of life, and need to beconsidered in all financial decisions

Depreciation is an expense that is not anegative cash flow; to the contrarydepreciation results in a tax shield (a

positive cash flow) that offsets taxes tosome extent


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Incremental Cash Flows Example a firm considering the establishment of a

branch office in a newly developing section ofa city

Incremental cash flowswill consist of thecosts of investment and operating the newoffice, costs that it would not have beenincurred unless the project was undertaken.It will also include the revenues derived fromthe business, benefits that would not havebeen realized otherwise.


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Sunk Costs

Sunk costsare cash outlays that havealready been incurred and cannot be

recovered regardless of any present orfuture decision.

Sunk costsare not incremental costs

and should not be included in capitalbudgeting analysis.


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Sunk CostExample

The firm and its branch office decision.

Suppose it hired a consulting firm two

years ago to do a site analysis. The$75,000 they paid is irrelevant, a sunkcost, because it cannot be recovered no

matter whether or not they decide tobuild their new branch office.


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Easier said than done

It may be psychologically impossible forpolicy makers to ignore sunk costsfor

future decisions, even though it isaccepted practice in higher circles. Thereis a natural tendency to continue with acourse of action, unable to see that it was

incorrect, even when there is evidence toshow the project is doomed to fail. Theterm used for this behavioral process isescalation of commitment


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Opportunity costs

Consider the firm with the branch officedecision.

Suppose they own land upon which thebranch could be built.

Should they ignore the cost of the landbecause they will not have a cash outlay to

acquire it? No, because if they dont use the land they

could sell it, for let us say $100,000.


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An opportunity costis a benefit

lost Opportunity cost is the maximum worth

of an asset among possible alternative

uses Opportunity costis thus a cash flow that

could be generated from assets the

organization already owns providedthey are not used for the project inquestion


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Externalities

Externalityis an economic term, whichcomes from the idea that we should

account for the direct effects, whetherpositive or negative, on someones

welfare that arise as a by-product of

some other persons or firms activity Synonyms are neighborhood,

interactive or spillover effects


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Externalities (more)

Consider the firms present customers who

might use the new branch office. Business

they do at the branch will reduce business atthe main office. That effect needs to beaccounted for in the analysis.

Branch office incremental revenues should be

reduced by the amount of decreasedrevenues at the main office, say $25,000/yr.

S E i C


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Summary - Economic Concepts

for use in discounted cash flow

analysis Do use

Incremental Cash inflowsand outflows

External benefits/costs

Opportunity costs Do not include

Accounting profits

Sunk costs


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Time Value of Money

What do you do with future incrementalcash flows of a project?

Calculate their Net Present Value! Start with displaying them on a time line


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Example

Firm invests $500,000 in a new branch nextyear, estimates it would return a net* of$100,000 ($500,000 in revenues offset by

$400,000 in expenses) annually beginning ayear latter. Sunk costs are not included.$100 opportunity cost is added to the initialinvestment for a first year total cost of $600,

000. $25,000/yr. external cost of the reducedrevenues at the home office should beaccounted for.

*i.e. the effects of taxes and depreciation are included


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Time Line: Incremental Cash Flows for the New Branch Office Project

Year 0 1 2 3 4 5 6 7 8 9

Cash Flow ($600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k

Underlying Data & Calculations for the New Branch Office Project

Investment $500k

Opportunity Cost 100k

External Cost 25k 25k 25k 25k 25k 25k 25k 25k 25k

Operations Cost* 400k 400k 400k 400k 400l 400k 400k 400k 400k

Revenues 500k 500k 500k 500k 500k 500k 500k 500k 500k

Net Cash In (out) (600k) 75k 75k 75k 75k 75k 75k 75k 75k 75k

*Includes effects of taxes and depreciation


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The dilemma facing the firm

Do you invest something now with a promiseof a return in the future? Its not a simplecase of foregoing $600,000 and recovering

$650,000($75,000 x 9) over the next 9 years.Dollars received in the future cannot beequated to dollars spent in the near term.Money in hand has more value than a like

amount of money in the future because of theopportunity it represents. The challenge ishow to account for this time value of money.


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Calculating the Projects NPV

Determine the discount rate

Calculate the present value of each

years cash flow Sum PV of future cash flows, then

subtract the investment to get NPV


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Discount rates are estimates of an

organizations cost of capital

If you as an individual were going toinvest in a project, the alternative use of

your money would be the clue to yourcost of capital.

A firms cost of capital depends on

where it would get the cash to fund theproject.


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Firms cost of capital

If it borrowed it, the cost of capital wouldbe the after tax interest rate it pays on a

loan or the bonds it issues. If the business sold more stock to raise

the money, the cost of capital would bethe rate of return the stockholders

expect to get.


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Cost of capital

If the project is funded with cash from thebusinesss accounts, then the cost of capital

would be the estimated rate of return onalternative investments.

Often, businesses get money from all threesources. When this is the case, they

estimate their cost of capital by a weightedaverage calculation. (Chapter 12)


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Riskier Projects > Higher

Discount Rate Weighted average

cost of capital is a

good discount ratefor average riskprojects

Higher risk projects

should use a higherthan average cost ofcapital


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NPV of the Firms Project

Year 0 1 2 3 4 5 6 7 8 9

Net

Cash

Flow

$

(600)

K

75 75 75 75 75 75 75 75 75

PVFactor

7%

1.000 .935 .873 .816 .763 .713 .666 .623 .582 .544

PV

@7%

$

(600)

70 66 61 57 53 50 47 44 41

NPV $

(111)

K


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Calculating NPV

Can use the Formula

Tables (as done on the previous slide)

Calculator

Spreadsheets make it really easy


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Making an Initial Decision

Follow a criterion, or decision rule.Whichrule to followdepends upon the

circumstances. If you are in businessand yourobjective is to turn a profitandincrease shareholders wealth, the rule

is simple: you accept any project thathas a positive net present value


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Special Rule

If projects are mutually exclusive, thenyou choose among them by picking the

one with the highest positive net presentvalue

Mutually exclusive projects are ones

that would not be chosen together, likebuilding a bridge and buying ferry boatsto traverse the same route.


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Sensitivity Analysis

Nothing is certain in the future. Sincethat is where the consequences of

capital budgeting decisions occur, wemust challenge the assumptionsunderlying our calculations.

We know estimates are wrong. Its amatter of how wrong they have to be tocause us to make a bad decision.


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Definition

Sensitivity analysisin general refers to arepetition of analysis using different

values for uncertain factors. If a reasonable change in an assumed

value results in a change in preference

among choices, then the decision issaid to be sensitive to that assumptionor that variable


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How to do what if

In capital budgeting, sensitivity analysismeasures the effect of changes to aparticular variable, say annual operatingcost, on a projects present value

All variables are fixed at their expectedvalues, except one. That one variable is

then changed, often by specifiedpercentages, and the resulting effect onpresent value is noted


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Sensitivity Analysis Routine

Spreadsheets and contemporary PCtechnology make the performance of

sensitivity analysis a piece of cake.Excel is ideally suited for sensitivityanalysis. Once a model is created, it is

very easy to change the values ofvariables and obtain new results.


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Usefulness

Identify those variables which potentiallyhave the greatest impact on success orfailure

Helps policy makers focus attention onthese variables that are probably mostimportant.

The sources of the estimates of thesevariables should be further scrutinized,and alternative sources sought.


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Sensitivity Analysis

Above all else, it serves as a riskassessment tool

If a reasonable change in an estimatecauses the outcome to go from asuccess to a failure, then the decision is

risky


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How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects ofchanges in single variables (sales, costs, etc.)on a project.

Scenario Analysis - Project analysis given aparticular combination of assumptions.

Worst Case Scenario

Best Case Scenario Most Likely Scenario

Summary


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Summary

Capital budget decisions are among themost important ones a firm can make

Steps. For each project:1. Estimate economic life

2. Estimate Incremental Cash Flows

3. Determine the discount rate

4. Calculate Net Present Value5. Order preference ofallprojects based on NPV

6. Do Sensitivity & scenario analysis

7. Interpret the results of the basic analysis and thesensitivity/scenario analysis, and make a decision.

8. Decide: lease or buy

9. Plan to implement what you can afford

10. Follow up, verify and adjust


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Capital Budget Decision Process

Discountedcash-flowanalysis

NPVInitial

Choice

Criterion

StartSensitivity &

ScenarioAnalys is

End:decision

AccountingProjections(Income

Statement)

DetermineRelevant

IncrementalCash Flow s

DetermineDiscount Rate

Cost ofCapital

Do theProject?

Lease orbuy

assessts?

yes

no

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