Chapter 10 Capital Budgeting Decisions Chapter 10 Outline

Chapter 10 Capital Budgeting Decisions

Chapter 10 Outline • What is capital budgeting? • Where does value come from? • Discounted cash flow and maximizing owners’ wealth The Capital Budgeting Process Evaluating Investment Projects 2 • • • The net present value method (NPV) The internal rate of return (IRR) Payback methods The profitability index What methods do companies really use?

The capital budgeting process A capital expenditure is a company’s investment in long-lived assets, which may be tangible assets, such as property, plants, and equipment, or intangible assets, such as research and development, copyrights, brand names, and franchise agreements. Tangible assets are hard, physical assets, whereas intangible ones are more abstract; it is easier for a company to borrow against tangible assets than against intangible ones. 3

What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Necessary for a company’s future.

Steps to capital budgeting Estimate cash flows (inflows & outflows). Assess riskiness of the cash flows Determine the appropriate cost of capital. Apply a capital budgeting technique (e. g. , NPV). Make a decision.

Where does value come from? A company that does not invest effectively will find itself at a competitive disadvantage, which in the extreme will affect its long-term survival. 6 In the short run, poor investment decisions will make a company less attractive than those that have better prepared themselves for the future. Recall from economics that to earn more than a “normal” profit, a company must have some type of comparative or competitive advantage.

What profit? Normal profit - the return on an investment that compensates the investor for explicit and implicit costs, where implicit costs include the opportunity cost of the investor’s capital. Economic profit - the return on an investment in excess of the normal profit. This is the essence of creating value: generating economic profits through capital investment. 7

Value A comparative advantage is the ability of a company to produce a product at a lower cost than its competitors. This includes the innate advantage that a company has over other companies due to access to resources, inputs, or markets. Examples of such access include ownership of oil fields, mines, chemicals, land, or production of inputs. 8

Value Competitive advantage - any strategy or company action that reduces the competition that the company experiences. These advantages include patents, copyrights, and 9 trademarks, which may keep competitors at bay, or at least slow down imitations of products. An example of competitive advantage is economies of scale; Another example of a competitive advantage is when a government grants a monopoly to a company.

Porter’s Five Forces Michael Porter reframed these basic economic principles by identifying five critical factors that determine the attractiveness of an industry in terms of the ability to generate economic profit, often referred to as the five forces: 1. 2. 3. 4. 5. 10 Entry barriers The threat of substitutes The bargaining power of buyers The bargaining power of suppliers Rivalry among existing competitors

Discounted cash flow (DCF) and maximizing owners’ wealth DCF valuation involves estimating future cash flows and comparing their discounted values with investment outlays required today. In this way, they are technically identical to the approaches used to evaluate bonds and stock. The only practical difference is that whereas the cash flows are fixed in valuing bonds and shares in the sense that the analyst cannot change them, in making capital investment decisions the analyst can change the underlying cash flows by changing the structure of the project. 11

What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one affects the acceptance of the other.

What is the difference between normal and nonnormal cash flow streams? Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

Techniques for evaluating cash flows Net present value Internal rate of return Modified internal rate of return Payback periods Profitability index

Net present value

The net present value (NPV) of an investment is the estimated value added of a project, which we calculate as the sum of the present value of all future after-tax incremental cash flows generated by an initial cash outlay, less the present value of the investment outlays. The NPV is the present value of the expected cash flows net of the costs needed to generate them. where CFn = the estimated cash flow at time n, and CF 0 = the initial cash outlay, which is a negative cash flow. 16

Sample projects End of year cash flows Year Project A Project B 0 -$100. 00 1 $25. 00 $0. 00 2 $50. 00 $0. 00 3 $75. 00 $155. 00 Assume that the required rate of return for each project is 10%

Net Present Value (NPV) The net present value is the sum of the PVs of all cash inflows and outflows of a project. The discount rate is the project’s cost of capital, r.

What is Project A’s NPV? Year Cash flow Present value of cash flow 0 -$100. 000 1 $25. 00 $22. 727 2 $50. 00 $41. 322 3 $75. 00 $56. 349 NPV = $20. 398

Solving for NPV: Financial calculator solution HP 10 B Enter CFs into the calculator’s CF register. CF 0 = -100 CF 1 = 25 CF 2 = 50 CF 3 = 75 Enter I/YR = 10, then NPV TI 83/84 Enter CFs for period 1 through 3 in a list: {25, 50, 75}, say L 1 Use NPV(. 1, -100, L 1)

Using Excel: Project A’s NPV A 1 2 3 4 5 6 B Year Cash flow 0 -$100. 00 1 $25. 00 2 $50. 00 3 $75. 00 NPV $20. 398 =NPV(0. 1, B 3: B 5)+B 2

Rationale for the NPV Method NPV = PV of inflows – PV of outflows = Added value If projects are independent, accept if the project NPV > $0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.

NPV profiles $60 $50 $40 $30 $20 $10 $0 -$10 -$20 -$30 Project A Project B 0% 2% 4% 6% 8% 10%12%14%16%18%20%22%24% Discount rate

The internal rate of return

Internal rate of return (IRR) The internal rate of return (IRR) is the discount rate that forces the present value of the inflows equal to the present value of the outflows, and the NPV = $0:

Solving for NPV: financial calculator solution HP 10 B Enter CFs into the calculator’s CF register. CF 0 = -100 CF 1 = 25 CF 2 = 50 CF 3 = 75 Then IRR TI 83/84 Enter CFs for period 1 through 3 in a list: {25, 50, 75} STO L 1 The IRR(-100, L 1)

Using excel: project A A 1 2 3 4 5 6 B Year Cash flow 0 -$100. 00 1 $25. 00 2 $50. 00 3 $75. 00 IRR 19. 44% What is the IRR of Project B? =IRR(B 2: B 5)

Rationale for the IRR method If IRR > project's cost of capital, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns. If IRR > project's cost of capital, accept project. If IRR < project's cost of capital, reject project.

Multiple IRRs Consider a project with the following cash flows: Cash Year flows 0 -$100 1 $195 2 -$100 3 $100 4 -$100 • What is the IRR of this project? • What happens when you try to solve this using a calculator?

Profile $4. 00 $3. 00 $2. 00 $0. 00 -$1. 00 -$2. 00 Two of the IRRs: 6. 528% & 35. 415% -$3. 00 -$4. 00 -$5. 00 -$6. 00 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34% 36% 38% 40% 42% 44% NPV $1. 00 Discount rate

Why are there multiple IRRs? A series of numbers that is being compounded or discounted can have as many roots as there are sign changes. [Rene Descartes, 16 th century philosopher] Are they useful? No. The IRRs in these cases are not useful in decision-making.

Comparing the NPV and IRR Methods If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive … If project's cost of capital > crossover rate, the methods lead to the same decision and there is no conflict. If project's cost of capital < crossover rate, the methods lead to different accept/reject decisions. BOTTOM LINE: Do not use IRR when deciding between or among mutually exclusive projects

Determining the cross-over rate The cross-over rate is the rate at which the two projects have the same NPV: Step 1: calculate the differences in cash flows Step 2: calculate the IRR of these differences Cash flows Year 0 1 2 3 IRR Project A Project B Differences -$100. 00 $0. 00 $25. 00 $50. 00 $75. 00 $155. 00 -$80. 00 19. 44% 15. 73% 4. 94%

NPV profiles $60 $50 $40 $30 $20 $10 $0 -$10 -$20 -$30 Project B Cross-over 4. 94% IRRA = 19. 44% IRRB = 15. 73% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% NPV Project A Discount rate

Reasons why NPV profiles cross Size (scale) differences The smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high project's cost of capital favors small projects. Timing differences The project with faster payback provides more CF in early years for reinvestment.

Reinvestment rate assumptions NPV method assumes CFs are reinvested at the project's cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

The modified internal rate of return

The MIRR The modified internal rate of return, (MIRR) is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at project's cost of capital. We often assume that cash flows are reinvested at the project's cost of capital, but that is not always appropriate. What are the investment opportunities?

The MIRR calculation Calculate the future value of all inflows, using the reinvestment rate as the compound rate Calculate the present value of all outflows, discounting at the required rate of return Solve for the rate that causes the PVoutflows = FVinflows

Why use MIRR versus IRR? MIRR assumes reinvestment at a more realistic reinvestment rate. MIRR avoids the multiple IRR problem. Managers like rate of return comparisons, and MIRR is better for this than IRR.

MIRR & financial calculators There is no built-in program for MIRR in financial calculators. Using most financial calculators requires the calculation of the FV for each inflow and then the summing of these FVs. Then use the PV, FV and n to solve for i. Trick to find TV: Calculate the NPV of the cash inflows (not outflows) at the reinvestment rate (be sure to use 0 for CF 0). Calculate the FV of this NPV using the reinvestment rate.

Example: Project A Assume that the reinvestment rate is 0%. Year 0 1 2 3 Project A Future value of Present value of cash flows cash inflows cash outflows -$100. 00 $25. 00 $50. 00 $75. 00 Sum $150. 00 -$100. 00 MIRR 14. 471%

Example: Project A, continued Assume that the reinvestment rate is 5%. Project A cash Future value of Present value of Year flows cash inflows cash outflows 0 -$100. 00 1 $25. 00 $27. 56 2 $50. 00 52. 50 3 $75. 00 Sum $155. 06 -$100. 00 MIRR 15. 745%

Example: Project A, continued Assume that the reinvestment rate is 10%. Project A cash Future value of Present value of Year flows cash inflows cash outflows 0 -$100. 00 1 $25. 00 $30. 25 2 $50. 00 55. 00 3 $75. 00 Sum $160. 25 -$100. 00 MIRR 17. 022%

Using Excel: Project A 6% reinvestment rate and 10% cost of capital A 1 2 3 4 5 6 Year 0 1 2 3 MIRR B Cash flow -$100. 00 $25. 00 $50. 00 $75. 00 16. 00% =MIRR(C 40: C 43, 0. 1, 0. 06)

Payback methods

Payback period - number of years required to fully recover the initial cash outlay associated with a capital expenditure Shorter payback periods are better, and usually this decision criterion is implemented by choosing a cutoff date and rejecting projects whose payback period is longer than the cutoff period. 47

Discounted payback period The discounted payback period alleviates the first shortcoming of the payback period by accounting for the time value of money. It is defined as the number of years required to fully recover the initial cash outlay in terms of discounted cash flows. Shorter periods are better, and projects with discounted payback periods before the cutoff date will be accepted. 48

Other issues

Capital rationing is the presence of a limit on the capital budget. When there is capital rationing, our goal is to select projects that maximize the total net present value, subject to constraints. 50

Comparing evaluation techniques 51

Comparing evaluation techniques (continued) 52

What methods do companies really use? Evaluation Criteria Used by Companies 53

Summary There alternative approaches to evaluating capital investment projects. The net present value method requires the calculation of the value added from the project. The internal rate of return is the yield on the project, which we derive by solving for the discount rate resulting in a zero net present value. 54

Summary The modified internal rate of return is return on a project assuming the reinvestment of project cash flows at a specific rate. The profitability index is the ratio of the present value of inflows to the present value of outflows. Paybacks methods (payback period and discounted payback) are used to gauge the liquidity of a project. 55

Practice problems

Problem 1 What is the modified internal rate of return for Project B if the reinvestment rate is 0%? 10%?

Problem 2 Calculate the NPV, the IRR, cross-over rate, and the MIRR for projects C & D, assuming a project cost of capital and reinvestment rate Cash flows of 8%: Year 0 1 2 3 Project C Project D -$100. 00 $80. 00 $40. 00 $20. 00 $160. 00 Which project would you choose and why?

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