Capital Budgeting Chapter 13 Capital Budgeting u The

Capital Budgeting Chapter 13

Capital Budgeting u The process of planning investments in assets whose cash flows are expected to extend beyond one year

Importance of Capital Budgeting u Long term impact u Timing u Substantial expenditures for which funds must be raised (either internally, externally, or both)

Project Classifications u Replacement decisions F decisions to determine whether to purchase capital assets to take the place of existing assets to maintain existing operations

Project Classifications u Expansion decisions F decisions to determine whether to purchase capital projects and add them to existing assets to increase existing operations

Project Classifications u Independent projects F projects whose cash flows are not affected by the acceptance or rejection of other projects

Project Classifications u Mutually exclusive projects F a set of projects where the acceptance of one project means the others cannot be accepted

Steps in the Valuation Process u 1. Determine the cost, or purchase price, of the asset u 2. Estimate the cash flows expected from the asset u 3. Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows u 4. Compute the present value of the expected cash flows u 5. Compare the present value of the expected cash inflows with the initial investment, or cost, required to acquire the asset

Cash Flow Estimation u Cash is different from accounting profits u Count cash flows after taxes u Only incremental cash flows are relevant to the accept/reject decision F the change in a firm’s net cash flow attributable to an investment project

Problems in Cash Flow Estimation u 1. Sunk costs F already incurred and cannot be recovered u 2. Opportunity costs F return on the best alternative use of an asset u 3. Externalities F the effect accepting a project will have on the cash flows in other areas of the firm

Problems in Cash Flow Estimation u 4. Shipping and Installation F the depreciable basis for an asset includes the purchase price plus shipping and installation u 5. Depreciation F depreciation is a non-cash expense affecting taxable income, thus taxes u 6. Inflation F expected inflation should be built into the expected cash flows

Identifying Incremental (Relevant) Cash Flows u Cash flows that occur only at the start of the project’s life u Cash flows that continue throughout a project’s life u Cash flows that occur only at the end, or termination of the project

Identifying Incremental (Relevant) Cash Flows u Initial investment outlay F includes the incremental cash flows associated with a project that occur only at the start of a project’s life, CF 0 ^

Identifying Incremental (Relevant) Cash Flows u Incremental operating cash flow F changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset

Incremental Operating Cash Flow

Identifying Incremental (Relevant) Cash Flows u Terminal cash flow F the net cash flow that occurs at the end of the life of a project, including the cash flows associated with: v 1. final disposal of the project v 2. returning the firm’s operations to where they were before the project was accepted

Cash Flow Estimation and the Evaluation Process u Expansion projects F initial investment outlays required F estimate the cash flows once production begins F terminal cash flow

Cash Flow Estimation and the Evaluation Process u Replacement analysis F must consider cash flow from old asset and new asset in decision F cash flows from the new asset take the place of cash flows from the old asset

Capital Budgeting Evaluation Techniques u 1. Payback u 2. Net present value (NPV) u 3. Internal rate of return (IRR)

Payback u Payback period is the length of time before the original cost of an investment is recovered from the expected cash flows

Net Present Value u NPV is a method of evaluating capital investment proposals by finding the present value of future net cash flows, discounted at the rate of return required by the firm u One of two discounted cash flow (DCF) techniques using time value of money that we will cover

Net Present Value

Discounted Payback u Discounted payback is the length of time it takes for a project’s discounted cash flows to repay the initial cost of the investment

Internal Rate of Return u IRR is the discount rate that forces the PV of a project’s expected cash flows to equal its initial cost u Similar to the YTM on a bond

Comparison of the NPV and IRR Methods u NPV profile is a graph (curve) showing the relationship between a project’s NPV and various discount rates (required rates of return) u IRR is at the point where the NPV profile crosses the X axis

NPVs and the Required Rate of Return u Crossover rate F the discount rate at which the NPV profiles of two projects cross and, thus, at which the project’s NPVs are equal

Independent Projects u NPV and IRR will both lead to the same decision F if a project’s NPV is positive, its IRR will exceed k, while if NPV is negative, k will exceed the IRR

Mutually Exclusive Projects u If NPV profiles cross, NPV and IRR decisions may conflict depending on discount rate selected F project size differences F timing differences v reinvestment rate may not match IRR u NPV method is preferred

Multiple IRRs u A project can have two or more IRRs F unconventional cash flow pattern v large outflow during or at the end of its life F NPV profile is required

Conclusions on the Capital Budgeting Decision Methods u Payback and discounted payback indicate risk and liquidity of a project u NPV gives a direct measure of the dollar benefit to the shareholders u IRR provides information about a project’s “safety margin” u IRR reinvestment assumption may be unrealistic u Watch out for multiple IRRs

Incorporating Risk in Capital Budgeting Analysis u Stand-alone risk F the risk an asset would have if it were a firm’s only asset F measured by the variability of the asset’s expected returns

Incorporating Risk in Capital Budgeting Analysis u Scenario analysis F a risk analysis technique in which “good” and “bad” sets of financial circumstances are compared with a most likely, or bestcase situation

Incorporating Risk in Capital Budgeting Analysis u Worst-case scenario F an analysis in which all of the input variables are set at their worst reasonably forecasted values

Incorporating Risk in Capital Budgeting Analysis u Best-case scenario F an analysis in which all of the input variables are set at their best reasonably forecasted values

Incorporating Risk in Capital Budgeting Analysis u Base case F an analysis in which all of the input variables are set at their most likely values

Incorporating Risk in Capital Budgeting Analysis u Corporate (within-firm) risk F risk not considering the effects of stockholders’ diversification F measured by a project’s effect on the firm’s earnings variability

Incorporating Risk in Capital Budgeting Analysis u Beta (market) risk F that part of a project’s risk that cannot be eliminated by diversification F measured by the project’s beta coefficient

Corporate (Within-Firm) Risk u Diversification (risk reduction) F as long as assets are not perfectly positively correlated some diversification can be achieved F adding projects can help reduce corporate risk

Beta (or Market) Risk u Project required rate of return, kproj F the risk adjusted required rate of return for an individual project F kproj = k. RF + (k. M - k. RF) proj

Beta (or Market) Risk u Pure play method F estimating beta of a project using firms whose only business is the product in question to approximate its own project’s beta

How Project Risk is Considered in Capital Budgeting Decisions u Risk-adjusted discount rate F required rate of return that applies to a particularly risky stream of income F equal to the risk-free rate of interest plus a risk premium appropriate for the level of risk attached to a particular project’s income stream

Capital Rationing u A situation in which a constraint is placed on the total size of the firm’s capital investment

Multinational Capital Budgeting u Repatriation of earnings F process of sending cash flows from a foreign subsidiary back to the parent company

Multinational Capital Budgeting u Exchange rate risk F uncertainty associated with the price at which the currency from one country can be converted into the currency of another country

Multinational Capital Budgeting u Political risk F the risk of expropriation of a foreign subsidiary’s assets by the host country, or of unanticipated restrictions on cash flows to the parent company

End of Chapter 13 Capital Budgeting