Capital Budgeting FIL 341 Keldon Bauer, PhD
Introduction • The most difficult part of applying capital budgeting techniques is estimating the cash flow. • To make these estimates in large corporations one must: • Coordinate with other departments • Ensure all participants use the same assumptions. • Exclude any obvious biases!
Relevant Cash Flows • When making capital budgeting decisions, relevant cash flows include: • Cash flows after tax. • Some non-cash items (such as depreciation) affect the cash flow because they act as a tax shield. • Only use incremental cash flows.
Cash Flow versus Income • In capital budgeting only incremental (marginal) cash flow is used. • Non-cash items in the income statement can still be important, because they affect taxable income • which in turn affects taxes paid - which are in cash! • Examples: Depreciation, amortization, etc.
Cash Flow versus Income • Most of the time, rough estimates of cash flow are used: • Net cash flow = Net income + Depreciation
Incremental Cash Flows • In addition to looking only at cash flow (rather than income), we are only interested in the incremental cash flow. • Incremental cash flow is the additional cash flow (which can be negative) in adopting the project. • In other words we are trying to capture the marginal benefit of adopting the project.
Incremental Cash Flows • The only cash flows we consider, therefore, are those that are different once the project is adopted. Things to include (or not) include: • Sunk Costs: Cash outlays already made should NOT be considered as incremental cash flows. The same can be said for cash outlays that would be made anyway - despite what a cost-accountant might do!
Incremental Cash Flows • Opportunity Costs: Any currently owned assets slated for the project could be earning return from “the next best alternative.” Forgoing that cash flow is a cost. • Externalities: The effect adoption might have on current projects of the firm. Will you steal sales from other divisions? Will you be able to cross-sell other products?
Incremental Cash Flows • Shipping & Installation Costs: Don’t forget to include the cost of shipping and installation (in time zero). This cost is usually capitalized and depreciated - affecting the after-tax cash flow. • Inflation: It is included in the cost of capital make sure it is included in revenue and expense projections.
Incremental Cash Flows • Incremental Financing Costs: Include any loan origination fees, debt or equity floatation costs, etc. Again only use the marginal costs, and don’t include the ongoing costs (that is included in the cost of capital or discount rate).
Identifying Incremental CF • Incremental cash flows can be classified as: • Initial Outlays: Cash flows that occur only at the start of the project’s life, t0. • Operating Cash Flows: Cash flows that continue throughout the project’s life, t1 - tn. • Terminal Cash Flows: Cash flows that occur only at the end, or termination, of the project, tn.
Initial Investment Outlays • Incremental cash flows at the beginning of a project’s life. • If it is a replacement decision - take into account the cash flow associated with disposal of the old equipment (net of tax). • Include net change in working capital - accounts receivable, inventory, etc.
Operating Cash Flows • These should represent incremental operating cash flows as a result of adoption of the project. • Can be simplified as change in cash revenues - change in cash expenditures - change in taxes.
Terminal Cash Flows • Net cash flows from: • Final disposal of project • Returning the firm’s operations to normal (including returning working capital to normal levels).
Example – New Project You work as the financial manager of a natural fertilizer preparation and packaging plant. The firm is introducing a new product, which although natural, is also packed with added plant nutrients, such as minerals and vitamins. To convey the message of high content fertilizer it goes by the name of Full-O-Vit (full of vitamins). This new product is only going to be offered over a five year basis. To produce this new fertilizer, you will need new equipment, which will cost $150,000 base cost, with shipping and installation costing another $20,000. In addition, you will need to increase inventories by $6,000. Your research has led you to believe that you can sell 25,000 bags of high content natural fertilizer for $9.50 per bag. The cost of the contents, packaging and shipping are expected to be $4.50 per bag. The annual fixed costs of the venture are expected to be $40,000. For simplicity, we will assume that the cost of the project will be 100 percent depreciated over the five-year life of the project, using straight-line depreciation. Furthermore, the cost of removing the equipment will approximate the market value at the end of the project, so it will essentially be worthless on the books and in actuality. Like the book, we will assume a tax rate of 34%.
Net Present Value • The philosophy behind the net present value (NPV) is how should adoption of the project affect the overall value of the firm. • NPV is the sum of all outlays in present value terms. • Since outlays are negative, and inflows are positive, the net represents addition to value of the firm.
NPV - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.Assume a 9% discount rate.
NPV - Excel • Excel has some unnecessary challenges doing NPV. • The NPV function assumes that all cash flows begin in year 1 (not in year 0), so the easiest way of getting it to do NPV correctly is: =NPV(Rate, Range of CF1 : CFn) + CF0 For example: =NPV(9%,A3:A7)+A2
-$1,500 $412.84 2 3 4 5 0 1 9% $387.17 $362.93 $340.04 $450 $460 $470 $480 $490 $318.47 NPV - Example 1 $ 321.45 = Net Present Value
9% -$3,000 $755 $855 $955 $1,054 $1,150 $692.66 2 3 4 5 0 1 $719.64 $737.44 $746.68 $747.42 NPV - Example 2 $ 643.83 = Net Present Value
NPV - Example Excel Formula: = NPV(18%, B3:B7)+B2 = $321.45 Excel Formula: = NPV(18%, C3:C7)+C2 = $643.83
Internal Rate of Return • The internal rate of return (IRR) represents the effective interest earned on the investment. • The internal rate of return, therefore, is defined as the discount rate at which NPV equals zero. • The only way to solve this problem is for a computer or a calculator to iterate to the answer.
IRR - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.
IRR - Example Excel Formula: = IRR(B2:B7) = 16.82% Excel Formula: = IRR(C2:C7) = 16.37%
IRR Problems • IRR has two major problems. • First, it assumes that all cash inflows will earn the IRR rate instead of the much more likely discount rate. • Second, depending on the cash flow streams there can be more than one IRR.
Multiple IRRs • As an example of more than one IRR, let’s assume you have a project that will return a net $4,000 in year zero (salvage of old machine, and financing, etc.), nets a negative $25,000 in year one, and finishes with a positive $25,000 in year two.
Multiple IRRs - Example • Since the IRR is defined as the discount rate which yields an NPV of zero:
Multiple IRRs - Example • Multiplying both sides by (1+k)2 yields: Factoring the above polynomial: k = IRR = 25% or 400%
Note on MIRRs • Modified IRRs (or MIRRs) can be used in place of an IRR, and all of the problems will be solved. • For Excel to yield an IRR, it needs the cash flows. You will also need the finance rate (your WACC), and the reinvestment rate (the rate at which you will be able to reinvest proceeds). • These two rates can be the same.
Notes on MIRRs - continued • To get Excel to calculate an MIRR use the following formula: =MIRR(Cash Flow Range, WACC, Reinvest %) For example: =MIRR(A2:A7, 9%, 9%)
MIRR - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.Assume a 9% discount rate.
MIRR - Example Excel Formula: = MIRR(B2:B7, 9%, 9%) = 13.32% Excel Formula: = MIRR(C2:C7, 9%, 9%) = 13.32%
Full-O-Vit Summary Example If the WACC for Full-O-Vit is 18%, and the cash flows are as follows:
Full-O-Vit Summary Example • NPV = $38,207.05 • IRR = 27.16% • MIRR = 22.73% • ADOPT THE PROJECT!!
Replacement Example The company is considering the purchase of a new packaging machine. The old one is currently being depreciated at $10,000 per year (straight-line), and is scheduled to end in five years with no remaining book value. If you don’t replace it, you will be lucky to get it removed for the amount you could salvage it for, so you don’t expect any profit in five years. If you replace it now, you believe you can salvage it for $40,000 (net) and buy a new machine for $160,000, plus $12,500 shipping fee and another $10,500 for installation. The machine will reduce the operating costs of the company by $75,000 per year. The new machine will be depreciated using the three-year MACRS (for simplicity purposes). The useful life of this machine is five years, and is expected to yield $1,000 in net salvage value at the end of the five years. Again, you may assume a tax rate of 34%. If you have a required return of 18%, should you invest in the new machine?
Full-O-Vit Summary Example • NPV = $50,274.03 • IRR = 34.38% • MIRR = 25.49% • ADOPT THE PROJECT!!
Adjusting for Project Risk • So far, we have assumed that all business risks have been similar to current business risks. • What if the business risks for the project are vastly different? • Then adjust the required equity return for the project’s risk using a pure play analysis.
Finding a Project’s Beta • Pure Play Method • Find a publicly traded company (or many of them) that are in the same line of business as the proposed project. • Estimate the publicly traded company’s beta (or many if you have them). • If more than one is used, average the betas (after adjusting for differences in leverage).
Pure Play • For practical purposes, all similar betas should be unlevered, then averaged. • Finally, the beta should be relevered to the firm’s target capital structure. • The new beta should be used for the required equity return in the WACC for the project.