Capital Budgeting FIN 461: Financial Cases & Modeling

1. Capital BudgetingFIN 461: Financial Cases & Modeling George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

2. Typical Capital Budgeting System W. P. Carey School of Business

3. Calculating Accounting Rate of Return W. P. Carey School of Business

4. Calculating Payback Period W. P. Carey School of Business

5. Calculating Discounted Payback Period W. P. Carey School of Business

6. Calculating NPV W. P. Carey School of Business

7. Calculating NPV… W. P. Carey School of Business

8. Use Nominal or Real WACC? • Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment • Common in capital budgeting is the use of market rates of return at the time of the analysis • Market interest rates have embedded an assumption about inflation • Use nominal cash flows to reflect the same inflation rate as that embedded in discount rate. W. P. Carey School of Business

9. Risk-Return Tradeoff for Projects • Projects plotting above the security market line (SML) have rates of return in excess of their required market rates • Positive NPVs • Projects plotting below the SML have rates of return less than their required market rates • Negative NPVs • Projects plotting on the SML earn their market rates • Zero NPVs. W. P. Carey School of Business

10. Calculating IRR W. P. Carey School of Business

11. Illustration for Calculating IRR W. P. Carey School of Business

12. IRR & Required Risk-Adjusted Rate • Appropriate rates for comparing project returns are those falling on the upward sloping market risk-return trade-off curve • Not the firm’s horizontal cost of capital line, WACC • WACC is only appropriate for evaluating projects with risk comparable to the level of risk of the firm • “Carbon copy” projects. W. P. Carey School of Business

13. Size Problem W. P. Carey School of Business

14. Cash Flow Pattern Problems W. P. Carey School of Business

15. Multiple IRR Solutions W. P. Carey School of Business

16. Undervaluation of Later Cash Flows W. P. Carey School of Business

17. Calculating the Profitability Index W. P. Carey School of Business

18. Comparison of Project Rankings • Project B is better than project A • Project B continues to earn cash flows longer • Project D is more desirable than project C • Although both projects generate the same amount of cash flows, project D does it earlier • Unanswered question: • Is Project D better than project B? W. P. Carey School of Business

19. Sunk Costs W. P. Carey School of Business

20. Salvage Value Comparisons W. P. Carey School of Business

21. Calculating Initial Investment W. P. Carey School of Business

22. Calculating Annual Operating Cash Flows W. P. Carey School of Business

23. Alternatively, Calculating Annual Operating Cash Flows… W. P. Carey School of Business

24. Calculating Terminal Cash Flows W. P. Carey School of Business

25. Salvage Value: Present vs. Future W. P. Carey School of Business

26. Another Topic:Competing Projects • Assume projects • Mutually exclusive • On-going • Different economic lives • How do you select the correct project? W. P. Carey School of Business

27. Example • There are times when application of the NPV rule can lead to the wrong decision • Consider a factory which must have an air cleaner • The equipment is mandated by law, so there is no “doing without” • There are two choices: • The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years • The “cheaper cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years • Which one should we choose? W. P. Carey School of Business

28. Example … • At first glance, the cheap cleaner has the “better” NPV (r = 10%): • Overlooks the fact that the Cadillac cleaner lasts twice as long • When we incorporate project life, the Cadillac cleaner is actually cheaper. W. P. Carey School of Business

29. -$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100 0 1 2 3 4 5 6 7 8 9 10 -$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500 0 1 2 3 4 5 6 7 8 9 10 Example … • The Cadillac cleaner time line of cash flows: • The “cheaper cleaner” time line of cash flows over ten years: W. P. Carey School of Business

30. Investments of Unequal Lives • Replacement Chain • Repeat the projects forever, find the PV of that perpetuity • Assumption: Both projects can and will be repeated • Matching Cycle • Repeat projects until they begin and end at the same time—like we just did with the air cleaners • Compute NPV for the “repeated projects” • The Equivalent Annual Annuity (EAA) Method. W. P. Carey School of Business

31. Equivalent Annual Cost Method • Equivalent Annual Annuity Method • Provides the value of the level payment annuity that has the same PV as the original set of cash flows • NPV = EAA × ArT • For example, the EAA for the Cadillac air cleaner is $750.98 Annuity Table 10%, 10 years = 6.1446 The EAA for the cheaper air cleaner is $763.80, which confirms our earlier decision to reject it. W. P. Carey School of Business

32. Another Example:Calculating EAA W. P. Carey School of Business

33. Human Face of Capital Budgeting • NPV of a project  based on assumptions • Managers must be aware of optimistic bias in these assumptions made by supporters of the project • Companies need control measures to remove bias • Analysis done by a group independent of individual or group proposing the project • Analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential • Another side of determining which projects receive funding – storytelling • Best analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense. W. P. Carey School of Business

34. The End W. P. Carey School of Business