Topics in Capital Budgeting

1. Topics in Capital Budgeting Richard MacMinn

2. Objectives • Study how to determine cash flows for capital budgeting analysis • Study capital budgeting under uncertainty • Study how to incorporate risk in capital budgeting decisions. Richard MacMinn

3. Guidelines for Capital Budgeting • Use cash flows rather than accounting profits • Cash flows correctly reflect the timing of benefits and costs • Examine cash flows on an after-tax basis • Only include incremental after-tax cash flows • Cash flows with the new project versus cash flows without the new project Richard MacMinn

4. Guidelines for Capital Budgeting • Beware of cash flows diverted from existing products • Decide if overhead costs are truly incremental cash flows • Ignore interest payments and financing flows as they are accounted for when the cash flows are discounted back to present Richard MacMinn

5. Inflation & Capital Budgeting • Increased inflation will cause the required rate of return on project to rise. • Both anticipated cash inflows and outflows could be affected by inflation. • The salvage value of the project could be affected by inflation. • The fact that depreciation charges do not change with inflation also distorts capital-budgeting decisions. Richard MacMinn

6. Measuring The Cash Flows • A project’s cash flows can be classified as: • Initial outlay • Differential cash flows • Terminal cash flow Richard MacMinn

7. Example Richard MacMinn

8. Initial Outlays • The installed cost of the asset • In case of a replacement decision, the after-tax cash flow associated with the sale of the old machine • Additional non-expense outlays incurred, e.g., Working capital investments • Additional expenses on an after tax basis, e.g., Training Richard MacMinn

9. Initial Outlays *The tax savings is the marginal tax rate times the difference $15,000 - $10,000, i.e., depreciated value minus salvage value. Richard MacMinn

10. Differential Cash Flows • Incremental after-tax cash flows resulting from increased revenue from the proposal • Any labor and/or material savings incurred • Increases in overhead incurred • Do not include any financing charges as they are implicitly taken care of in the discounting process Richard MacMinn

11. Differential Cash Flows *The increased depreciation charges are calculated as $12,000 - $3,000. Richard MacMinn

12. Terminal Cash Flows • The project’s salvage value plus any taxable gains or losses associated with the project • Any terminal cash flows needed, perhaps for disposal of obsolete equipment • Recovery of any non-expense cash outlays associated with the project, such as recovery of increased working-capital needs associated with the proposal Richard MacMinn

13. $17,580 $17,580 $17,580 $17,580 $17,580 0 1 2 3 4 5 t $48,300 Terminal Cash Flows • The salvage value of the new machine is zero and so there is no terminal cash flow in this example • The cash flows for the proposed project are as shown: Richard MacMinn

14. Risk and Investment Decisions • The risk of an investment project is defined as the variability of its cash flows from the expected cash flows. • In capital budgeting, project’s risk can be looked at in the following three levels: • Project Risk • Firm Risk • Systematic Risk Richard MacMinn

15. What measure of risk is relevant for capital budgeting? • According to CAPM, systematic risk is the only relevant risk for capital budgeting purposes. • For undiversified shareholders including owners of small corporations the relevant measure of risk may be the project’s contribution-to-firm risk. This measure is more appropriate if there are cost associated with bankruptcy. Richard MacMinn

16. Methods for Incorporating Risk into Capital-Budgeting • Certainty Equivalent Approach • In this method the financial manager substitutes the certain dollar amount that he or she feels is equivalent to the expected but risky cash flows offered by the project. • In effect, the manager is indifferent between both a safe set of cash flows and the original set of risky cash flows. Richard MacMinn

17. Methods for Incorporating Risk into Capital-Budgeting • Risk Adjusted Discount Rates • In this method if the risk associated with the project is more then the discount rate is adjusted upwards to compensate for the risk. • The expected cash flows are then discounted back to present at the risk-adjusted discount rate. Richard MacMinn

18. Certainty Equivalent versus Risk Adjusted Discount Rate • In the certainty equivalent approach, the expected cash flows are adjusted downwards to incorporate risk of the project. • In the risk adjusted discount rate approach, the expected cash flows are unchanged but the required rate of return is adjusted upwards to incorporate risk of the project. • In either case the net result is a decrease in the NPV of the investment proposal. Richard MacMinn

19. The Systematic Risk of a Project • In order to determine the risk adjusted discount rate for a project we need to estimate the systematic risk, i.e., the project beta. • Beta can be estimated using • Accounting Return Data Method • Pure Play Method Richard MacMinn

20. The Capital Budgeting Decision m rf + b (ERm – rf) b Richard MacMinn

21. Other Sources and Measures of Risk • Time Dependence of Cash Flows • Many times, especially with the introduction of a new product the cash flows experienced in the early years affect the size of the cash flows experienced in later years. This is called time dependence of cash flows. • Skewness • A distribution that is not symmetric is said to be skewed. • When distributions are skewed, the expected value and standard deviation alone may not be enough to differentiate between two distributions or risks. Richard MacMinn

22. Methods for Evaluating Risk in Capital Budgeting • CAPM • Simulation • Sensitivity Analysis • Probability Trees Richard MacMinn

23. Summary • Measured cash flows • Incorporated risk • Considered capital budgeting methods Richard MacMinn