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## Capital Budgeting

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**Capital Budgeting**MBA Fellows Corporate Finance Learning Module Part I**Topic Outline**• Capital Budgeting • Project Classifications • Capital Budgeting Decision Criteria • Reinvestment Assumptions • Post Audit • Replacement Chain Approach**Estimating Cash Flows**• After-tax cash flows not accounting profits are the basis for evaluating projects. • Incremental Cash Flows - the difference between the cash flows to the firm with the project compared to the cash flows to the firm without adopting the project.**Incremental Cash Flows**• Indirect costs such as: increases in cash balances, receivables, and inventory necessitated by the project should included. • Sunk Costs - not included because they have already occurred and are not affected by the current decision.**Opportunity Costs**• Used to measure resources used in the project. • Opportunity cost of resources are the cash flows they would generate if not used in the project under consideration.**Initial Cash Outlay**• New project costs + installation/shipping • Increases in Net Working Capital • Net proceeds from the sale of existing assets. • Taxes associated with the sale of existing assets or the purchase of a new one.**Incremental After Cash Flows**• Increased revenue offset by increased expenses. • Labor and material savings • Increases in overhead • Tax Savings from an increase in depreciation expense**Terminal Cash Flows**• Cash flows occurring at the end of the of a project’s life must be included in the analysis. • Recovery of new working capital - can be a cash inflow, but has not tax consequences. • Incremental Salvage Value**Incremental Salvage Value**• The difference between the salvage value with the project and without the project. • Sale of Asset > Book Value: Gain/Taxes due. • Sale of Asset < Book Value: Loss/Tax savings. • Sale of Asset=Book Value: No taxes**Salvage Value & Taxes**• Gain - taxes as operating income, with taxes due equal to the marginal tax rate times the amount of the gain. • Loss - treated as an operating lost to offset operating income. The tax savings is the marginal tax rate times the amount of the loss.**Interest Charges**• Not considered in estimating project’s cash flows so that the project’s value can be considered independent of the method of financing. • The cost of capital (required rate of return) used to discount the project’s cash flows includes these costs.**Depreciation - MACRS**• Modified Accelerated Cost Recovery System (MACRS). • Depreciable base - not adjusted for salvage value: = Cost + Installation/shipping Costs**Summary of After-tax Cash Flows**• Initial Outlay • Incremental Cash Flows Over the Project’s Life • Terminal Cash Flows**Capital Budgeting**• The process of planning for the purchase of long-term assets whose cash flows are expected to continue beyond one year. • Capital Expenditures - cash outlays which are expected to generate future cash benefits (cash inflows).**Capital Budgeting Projects**• Replacement/maintenance of fixed assets. • Expansion of existing products or markets. • Expansion into new products or markets. • Research Development • Investments in education and training. • Cost reduction projects.**Capital Budgeting Process**• Generating Capital Investment Proposals • Estimating cash flows • Evaluating alternatives and selecting projects to be implemented. • Reviewing and auditing prior investment decisions.**Capital Budgeting Decision Rules**• Payback Period • Discounted Payback Period • Net Present Value (NPV) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR) • Profitability Index**Payback Period**• The expected number of years it takes to recover a project’s costs, or • The expected number of years required for the cumulative net cash flows from a project to equal the initial cash outlay. PB = Yr before Recovery + Unrecovered Cost Start of Yr. Cash Flow During Year**Payback for Project L(Long: Most CFs in out years)**2.4 0 1 2 3 CFt -100 10 60 100 80 Cumulative -100 -90 -30 0 50 PaybackL = 2 + 30/80 = 2.375 years**Project S (Short: CFs come quickly)**1 1.6 2 0 3 CFt -100 70 100 50 20 -100 -30 0 20 40 Cumulative PaybackS = 1 + 30/50 = 1.6 years**Strengths of Payback:**1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.**Discounted Payback Period**• Expected number of years required to recover the initial cash outlay from discounted cash flows • Expected cash flows are discounted at the project’s cost of capital. • Advantages: • Easy to calculate and understand • Considers time value of money • Disadvantage: ignores the time value of money e cash flows occurring after the payback period.**Discounted Payback: Uses discounted**rather than raw CFs. 2 0 1 3 10% -100 10 60 80 CFt 60.11 -100 9.09 49.59 PVCFt Cumulative - 41.32 -100 -90.91 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs = Recover invest. + cap. costs in 2.7 yrs.**Net Present Value (NPV)**• The present value of the stream of expected future net cash inflows from a project minus the project’s initial cash outlays. NPV = PVNCF - Initial Cash Outlay NPV = - Initial Cash Outlay**NPV Decision Rule**Accept project when NPV > 0 • The present value of the project’s net cash flows exceeds the project’s initial outlay. Reject project when NPV < 0 • The present value of the net cash flows is less than the initial outlay**NPV**Advantages: • Accounts for the time value of a project’s cash flows over its entire life. • Easy to use and understand - Positive NPV projects increase the wealth of the firm’s owners, i.e. (maximizing shareholder wealth). • Accept/Reject Decisions are clear. Disadvantages • Requires detailed long-term forecasts of the project’s cash inflows and outflows.**EVA & NPV**• NPV is equal to the PV of the project’s future EVAs. • Therefore, accepting positive NPV projects should result in a positive EVA for the company, and a positive MVA.**NPV: Sum of the PVs of inflows and outflows.**Cost often is CF0 and is negative.**What’s Project L’s NPV?**Project L: 0 1 2 3 10% -100.00 10 60 80 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98.**Calculator Solution**Enter in CFLO for L: -100 10 60 80 10 CF0 CF1 CF2 CF3 I NPV = 18.78 = NPVL**Rationale for the NPV Method**NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.**NPV method: Which project(s) should be accepted?**• If Projects S and L are mutually exclusive, accept S because: NPVs > NPVL . • If S & L are independent, accept both; NPV > 0.**Internal Rate of Return (IRR)**• The discount rate which equates the PV of the net cash flows of the project with the PV of the initial investment. • Or, the discount rate which results in a NPV equal to zero. • NPV = 0 =**IRR**• Disadvantages: • Requires detailed long term forecasts of the incremental benefits and costs. • Unusual cash flow patterns (inflows and outflows) can result in multiple IRRs. • Assumes cash flows over the life of the project are reinvested at the IRR.**Internal Rate of Return: IRR**0 1 2 3 CF0 CF1 CF2 CF3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.**NPV: Enter k, solve for NPV.**IRR: Enter NPV = 0, solve for IRR.**What’s Project L’s IRR?**0 IRR = ? 1 2 3 -100.00 10 60 80 PV1 PV2 PV3 0 = NPV Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.**N**I/YR PV PMT FV Find IRR if CFs are constant: 0 1 2 3 IRR = ? -100 40 40 40 INPUTS 3 -100 40 0 9.70% OUTPUT Or, with CFLO, enter CFs and press IRR = 9.70%.**Q. How is a project’s IRR**related to a bond’s YTM? A. They are the same thing. A bond’s YTM is the IRR if you invest in the bond. 0 1 2 10 IRR = ? ... -1,134.2 90 90 1,090 IRR = 7.08% (use TVM or CFLO).**Rationale for the IRR Method**If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. Profitable.**Steps in Determining NPV, IRR**1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.**NPV vs. IRR**• NPV assumes that the project’s cash flows are reinvested at the the cost of capital. • IRR assumes that the project’s cash flows are reinvested at the IRR. • When 2 or more mutually exclusive projects are acceptable using the IRR and NPV criteria,, and if the two criteria disagree, which is best, the NPV criteria is generally preferred.**Reinvestment Rate Assumptions**• NPV assumes reinvest at k (opportunity cost of capital). • IRR assumes reinvest at IRR. • Reinvest at opportunity cost, k, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.**NPV and IRR always lead to the same accept/reject decision**for independent projects: NPV ($) IRR > k and NPV > 0 Accept. k > IRR and NPV < 0. Reject. k (%) IRR**Mutually Exclusive Projects**NPV k < 8.7: NPVL> NPVS , IRRS > IRRL CONFLICT L k > 8.7: NPVS> NPVL , IRRS > IRRL NO CONFLICT IRRS S % k 8.7 k IRRL**To Find the Crossover Rate**1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles don’t cross, one project dominates the other.**Two Reasons NPV Profiles Cross**1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects. 2. Timing differences. Project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.**Modified IRR (MIRR)**• Discount rate that equates the present value of the project’s cash outflows with the present value of the project’s terminal value. • Terminal Value - the sum of the future value of the project’s cash inflows compounded at the required rate of return**MIRR**• Addresses the reinvestment assumption of IRR and the multiple IRR problem. • Allows the decision maker to to directly specify the appropriate reinvestment rate. • Key Assumption - all cash project inflows are invested at the required rate of return until the termination of the project.**MIRR**• Terminal value - take after-tax cash inflows and find their future value at the end of the project’s life, compounding at the required rate of return. • Then calculate the PV of the project’s cash out flows, using the required rate of return. • If the initial outlay is the only cash outflow, then the initial outlay is the PV of the cash outflows. • MIRR the discount rate that equates the PV of the cash outflows with the PV of the project’s terminal value.