1

Capital Budgeting

• Capital budgeting - A process of evaluating and planning expenditure on assets that will provide future cash flow(s).

2

Payback period

The number of years required to recover a project’s cost,

or how long does it take to recover the investment?

Pros:Provides an indication of a project’s risk and liquidity.

Easy to calculate and understand.

Cons:Ignores the TVM.

Ignores CFs occurring after the payback period.

3

Net Present Value

• Sum of the PVs of inflows and outflows

• CFt Period t Cash Flow, positive for inflows, negative for outflows.

• r discount rate

.10

tt

T

t r

CFNPV

4

NPV = PV Inflows – PV Outflows (Cost)

= Net gain in wealth.

Accept project if NPV > 0

Reject project if NPV < 0

Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.

NPV Decision rule.

5

IRR:Internal rate of Return

IRR is the discount rate that forces

PV inflows = PC outflow . This is the sameas forcing NPV = 0.

• IRR is the rate that solve the equation.

.010

t

tT

t IRR

CF

6

IRR Decision Rule

• r Discount rate

• If IRR > r, accept project.

• If IRR < r, reject project.

• Consistent with NPV

• If IRR > r NPV >0

7

NPV vs IRR• NPV assumes reinvest at r

(opportunity cost of capital).• IRR assumes reinvest at IRR.• Reinvest at opportunity cost, r,

is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.

8

NPV vs IRR• For mutually exclusive projects,

IRR does not consider project scale.

• Multiple outflow periods lead to multiple IRR.

9

Project Cash Flow

• Consider only incremental cash flows.

• Disregard sunken cost (sunken cost has no impact on future cash flows: it is irrelevant to shareholders)

• Opportunity cost of resources as project cost.

• Consider effect on other projects (externalities).

• Beware of inflation.

10

Depreciation and Cash Flows

• It is important to remember that when making financial decisions only timed cash flows are used– depreciation is an expense, but is

not a cash expense, and must be excluded

– the tax benefit of depreciation, however, is a cash flow, and must be included

11

Proposed Project A

• Capital equipment initial cost $240,000, all depreciable.

• Economic life = 4 years

• Salvage value = 25,000

• Depreciable using 3 year class MACRS.

• Sales: 100,000 units/year @ $2.

• Variable cost = 60% of sales.• Tax rate = 40%.• Discount rate = 10%.

12

Proposed Project A

1 Year 0 1 2 3 42 Equip 240,00034 Sales 200,000 200,000 200,000 200,0005 VC 120,000 120,000 120,000 120,0006 OI (4-5) 80,000 80,000 80,000 80,0007 Depreciation(2.0*25) 79,200 108,000 36,000 16,8008 EBT(6-7) 800 -28,000 44,000 63,2009 Tax(40%*8) 320 -11,200 17,600 25,280

10 NI(8-9) 480 -16,800 26,400 37,92011 OCF (10+7) 79,680 91,200 62,400 54,7201213 SV 25,00014 Tax(40%*13) 10,00015 After tax SV(13-14) 15,0001617 CF(-2+11+15) -240,000 79,680 91,200 62,400 69,72018 Discount Factor 1.00 1.10 1.21 1.33 1.4619 PV(17/18) -240,000 72,436 75,372 46,882 47,6202021 NPV 2,3102425 MACRS 33% 45% 15% 7%

13

Working Capital & Cash Flows

• Some cash flows do not occur on the income statement, but involve timing– working capital additions and

reductions are cash flows– at the end of a project, the sum of

the nominal changes in working capital is zero

14

Proposed Project A.1

• Working Capital – The difference between current assets and current liabilities.

• In capital budgeting Working capital is committed to the project and is fully recovered by the end of the project.

• Project requires $50,000 working capital in the initial year. The working capital is recovered when the project is terminated.

15

Proposed Project A.1

4 Sales 200,000 200,000 200,000 200,0005 VC 120,000 120,000 120,000 120,0006 OI (4-5) 80,000 80,000 80,000 80,0007 Depreciation(2.0*25) 79,200 108,000 36,000 16,8008 EBT(6-7) 800 -28,000 44,000 63,2009 Tax(40%*8) 320 -11,200 17,600 25,280

10 NI(8-9) 480 -16,800 26,400 37,92011 OCF (10+7) 79,680 91,200 62,400 54,7201213 SV 25,00014 Tax(40%*13) 10,00015 After tax SV(13-14) 15,000

15.1 WC 50,000 50,000 50,000 50,000 015.2 chg WC -50,000 0 0 0 50,000

1617 CF(-2+15.2+11+15) -290,000 79,680 91,200 62,400 119,72018 Discount Factor 1.00 1.10 1.21 1.33 1.4619 PV(17/18) -290,000 72,436 75,372 46,882 81,7702021 NPV -13,5392425 MACRS 33% 45% 15% 7%

16

Inflation and Capital Budgeting

• Assume annual inflation (π ) rate affect all project cash flow.

• We can:– Use nominal rate to discount

nominal cash flows– Use real rate to discount real cash

flow.

1)1(*)1( realnom rr

17

Proposed Project A.2

• Assume Project A faces inflation π = 5%

• Inflate cash flow by inflation rate (after period 1).

%5.151)05.1(*)10.1( nomr

18

Proposed Project A.2

7 Depreciation(2.0*25) 79,200 108,000 36,000 16,8008 EBT(6-7) 800 -24,000 52,200 75,8109 Tax(40%*8) 320 -9,600 20,880 30,324

10 NI(8-9) 480 -14,400 31,320 45,48611 OCF (10+7) 79,680 93,600 67,320 62,2861213 SV 28,94114 Tax(40%*13) 10,00015 After tax SV(13-14) 18,9411617 CF(-2+11+15) -240,000 79,680 93,600 67,320 81,22718 Discount Factor 1.000 1.155 1.334 1.541 1.78019 PV(17/18) -240,000 68,987 70,164 43,692 45,6432021 NPV -11,5152425 MACRS 33% 45% 15% 7%

19

Sensitivity Analysis• Will the project still be

economical if some of the underlying variables are incorrect?– We can check the effect on the

project of different variable and how sensitive is the project NPV to them

– For Example:• Sales Units

• Sales Price

• Variable Cost

• Life of the Project

20

Sensitivity Analysis• Project A, with $10,000 sales

increments.

• NPV Breakeven occurs at $187,985

A. NPV Sales Sensitivity

-30000

-20000

-10000

0

10000

20000

30000

40000

50000

100 150 200 250Thousands

Sales $

NP

V