Should we build this plant?

1. CHAPTER 11The Basics of Capital Budgeting Should we build this plant?

2. Steps in Capital Budgeting 1. Estimate Cash flows. 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.

3. Basic Framework for Decisions • Cash flow Evaluation • The Tough Part • Benefits & Costs • Risk & Return • Cost of capital is function of project risk • Mutually Exclusive Projects & Independent Projects

4. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.

5. Normal Cash Flow projects Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: 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.

6. Decision Rules • Payback Period • The number of years required to recover a project’s cost • A Very Simple, but Imprecise measure • Net Present Value (NPV) • NPV = Present Value of all cash flows • Accept positive NPV projects • Theoretically the best approach

7. 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.

8. Decision Rules • Internal Rate of Return (IRR) • Discount rate for which NPV = 0 • IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. • IRR is the same YTM. • Not suitable for mutually exclusive projects

9. Two Simple Projects • Project S and Project L • Cash Flows: S L • Year 0 -100 -100 • Year 1 10 70 • Year 2 60 50 • Year 3 80 20

10. Calculator Solution for Project L Enter in CFLO for L: -100 10 60 80 10 CF0 CO1 CO2 CO3 NPV = 18.78 = NPVL I NPVS = $19.98 IRRL = 18.13 IRRS = 23. 56

11. NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates: NPVS 40 29 20 12 5 NPVL 50 33 19 7 k 0 5 10 15 20 (4)

12. NPV ($) k 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5 Crossover Point = 8.7% S IRRS = 23.6% L Discount Rate (%) IRRL = 18.1%

13. 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

14. Modified IRR (MIRR) MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.

15. $158.1 (1+MIRRL)3 $100 = MIRR for Project L (k = 10%) 0 1 2 3 10% -100.0 10.0 60.0 80.0 10% 66.0 12.1 10% MIRR = 16.5% 158.1 -100.0 TV inflows PV outflows MIRRL = 16.5%

16. Chapter 12 - Cash Flow Estimation • What cash flows to use? • Incremental After-tax cash flows • Cash flows only • Opportunity costs & sunk costs • Side effects, externalities • Change in working capital • Ignore financing charges • Depreciation

17. Proposed Project - Minicase Ch. 12 • Cost: $200,000 + $10,000 shipping + $30,000 installation. • Depreciable cost $240,000. • Inventories will rise by $25,000 and payables will rise by $5,000. • Economic life = 4 years. • Salvage value = $25,000. • MACRS 3-year class.

18. Incremental gross sales = $250,000. • Incremental cash operating costs = $125,000. • Tax rate = 40%. • Overall cost of capital = 10%.

19. Set up without numbers a time line for the project CFs. 0 1 2 3 4 Initial Outlay OCF1 OCF2 OCF3 OCF4 + Terminal CF NCF0 NCF1 NCF2 NCF3 NCF4

20. Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

21. If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis? • Yes. The effects on the other projects’ CFs are “externalities”. • Net CF loss per year on other lines would be a cost to this project. • Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

22. Net Investment Outlay at t = 0 (000s) Equipment Freight + Inst. Change in NWC Net CF0 ($200) (40) (20) ($260) DNWC = $25,000 - $5,000 = $20,000.

23. Annual Depreciation Expense (000s) Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis = Depr. $ 79 108 36 17 $240

24. Year 1 Operating Cash Flows (000s) Year 1 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107

25. Year 4 Operating Cash Flows (000s) Year 1 Year 4 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107 $125 (17) $108 (43) $ 65 17 $ 82

26. Net Terminal Cash Flow at t = 4 (000s) Salvage value Tax on SV Recovery on NWC Net terminal CF $25 (10) 20 $35

27. What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.

28. Project Net CFs on a Time Line 0 1 2 3 4 (260)* 107 118 89 117 Enter CFs in CFLO register and I = 10. NPV = $81,573. IRR = 23.8%. *In thousands.

29. What is the project’s MIRR? (000s) 0 1 2 3 4 117.0 TV = 500.1 (260)* 107 118 89 (260) MIRR = 17.8%

30. If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold and the incremental CFs would be the changes from the old to the new situation.

31. Revenues. • Costs. • The relevant depreciation would be the change with the new equipment. • Also, if the firm sold the old machine now, it would not receive the salvage value at the end of the machine’s life.

32. What is cash flow estimation bias? • CF’s are estimated for many future periods. • If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK). • Studies show that forecasts often are biased (overly optimistic revenues, underestimated costs).

33. What steps can management take to eliminate the incentives for cash flow estimation bias? • Routinely compare CF estimates with those actually realized and reward managers who are forecasting well, penalize those who are not. • When evidence of bias exists, the project’s CF estimates should be lowered or the cost of capital raised to offset the bias.

34. What is option value? • Investment in a project may lead to other valuable opportunities. • Investment now may extinguish opportunity to undertake same project in the future. • True project NPV = NPV + value of options.

35. If 5% inflation is expected over the next 5 years, are the firm’s cash flow estimates accurate? • No. Net revenues are assumed to be constant over the 4-year project life, so inflation effects have not been incorporated into the cash flows.

36. Real vs. Nominal Cash flows • In DCF analysis, k includes an estimate of inflation. • If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. • This bias may offset the optimistic bias of management.

37. S and L are mutually exclusive and will be repeated. k = 10%. Which is better? (000s) 0 1 2 3 4 Project S: (100) Project L: (100) 60 33.5 60 33.5 33.5 33.5

38. S L CF0 -100,000 -100,000 CF1 60,000 33,500 Nj 2 4 I 10 10 NPV 4,132 6,190 NPVL > NPVS. But is L better? Can’t say yet. Need to perform common life analysis.

39. Note that Project S could be repeated after 2 years to generate additional profits. • Can use either replacement chain or equivalent annual annuity analysis to make decision.

40. Project S with Replication: Replacement Chain Approach (000s) 0 1 2 3 4 Project S: (100) (100) 60 60 60 (100) (40) 60 60 60 60 NPV = $7,547. Project L NPV = $6,190

41. EAA Solution • Project S • PV = Raw NPV = $4,132. • n = Original project life = 2. • k = 10%. • Solve for PMT = EAAS = $2,381. • Project L • PV = $6,190; n = 4; k = 10%. • Solve for PMT = EAAL = $1,953. • EAAS > EAAL so pick S.

42. If the cost to repeat S in two years rises to $105,000, which is best? (000s) 0 1 2 3 4 Project S: (100) 60 60 (105) (45) 60 60 NPVS = $3,415 < NPVL = $6,190. Now choose L.

43. Abandonment Option - Example Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Abandonment Value $5,000 3,100 2,000 0 NPV(no)= -$123, NPV(2)= $215, NPV(1) = -$273.

44. Chapter 13 - Risk Analysis & Real Options • Types of risk • Project risk and capital structure • Risky outflows • Effects of abandonment possibilities • Real options • Optimal capital budget

45. Risk Analysis & Types of Risk • Risk Analysis • Historic Data or Subjective Assessment? • Types of Risk • Stand-alone risk, Corporate risk, Market (or beta) risk • Measured by sNPV, sIRR, beta. • Will taking on the project increase the firm’s and stockholders’ risk?

46. How is each type of risk used? • Market risk is theoretically best in most situations. • However, creditors, customers, suppliers, and employees are more affected by corporate risk. • Therefore, corporate risk is also relevant.

47. Stand-alone risk is easiest to measure, more intuitive. • Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. • If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

48. What is sensitivity analysis? • Shows how changes in a variable such as unit sales affect NPV or IRR. • Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. • Answers “what if” questions, e.g. “What if sales decline by 30%?”

49. What is scenario analysis? • Examines several possible situations, usually worst case, most likely case, and best case. • Provides a range of possible outcomes.

50. What is a simulation analysis? • A computerized version of scenario analysis which uses continuous probability distributions. • Computer selects values for each variable based on given probability distributions and calculates NPV and IRR. • Process is repeated many times (1,000 or more) and Probability distribution of NPV and IRR produced.