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CAPITAL BUDGETING

What it is • Large investment in plant or equipment

with returns over a period of time.

• Investment may take place over a period of time

• A Strategic Investment Decision

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CAPITAL BUDGETING

Purpose

• Expansion

• Improvement

• Replacement

• R & D

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CAPITAL BUDGETING

What do we need to think about?• Location

• Infrastructure

• Labour

• Cash Flows

What is the most important?

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OVERALL AIMTo maximise shareholders wealth..

Projects should give a return over and above the marginal weighted average cost of capital.

Projects can be;• Mutually exclusive• Independent• Contingent

Process of Choice

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IDEAL SELECTION METHOD

Will• Select the project that maximises

shareholders wealth• Consider all cash flows• Discount the cash flows at the appropriate

market determined opportunity cost of capital

• Will allow managers to consider each project independently from all others

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SELECTION METHODS

• Payback

• RoA or RoI

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

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CHOICE PAYBACK

Project A Project B

Yr 0 - 1,000,000 - 1,000,000

Yr 1 + 1,100,000 + 500,000

Yr 2 + 200,000 + 500,000

Yr 3 - 100,000 + 500,000

Project A = Year .909

Project B = ?

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PAYBACK

Problems:-

• Ignores overall return

• Ignores impact of large flows

• Ignores timing of flows

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RoAProject A Project B

Yr 0 - 1,000,000 - 1,000,000

Yr 1 + 1,100,000 + 500,000

Yr 2 + 200,000 + 500,000

Yr 3 - 100,000 + 500,000

n

RoA Project A = Σ ( cashflows) ÷ Io

t=o n

• (200,000) = 66,666.66 ÷ 1,000,000 = .0666 or 6.67%

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Project B?

Problems?

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NET PRESENT VALUE

PROJECT A

Yr CF PV Factor @ 14% Present Value0 - 1,000,000 1.000 - 1,000,0001 500,000 .8772 438,6002 500,000 .7695 384,7503 500,000 .6750 337,5004 500,000 .5921 296,0505 - 500,000 .5194 - 259,700

NPV 197,200

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NET PRESENT VALUE

PROJECT B

- 1,000,000 900,000 200,000 200,000 100,000 100,000

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NET PRESENT VALUE

PROJECT B

- 1,000,000 - 1,000,000 900,000 789,480 200,000 153,900 200,000 135,000 100,000 59,210 100,000 51,940 NPV 189,530

Which project should we undertake?

Why?

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Internal Rate of ReturnProject AYr CF PVF@ 26% PV PVF@ 27% 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 500,000 .793651 = 396,825 .787401 393,7012 500,000 .629881 = 314,941 .620001 310,0003 500,000 .499906 = 249,953 .488190 244,0954 500,000 .396751 = 198,376 .384401 192,2005 - 500,000 .314881 = - 157,441 .302678 -

151,3392,654 -

11,343InterpolationIRR = 26.19%

Project B 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 900,000 = 714,286 708,6612 200,000 = 125,976 124,0023 200,000 = 99,981 97,6384 100,000 = 39,675 38,4405 100,000 = 31,488 30,268

IRR = 27% 11,406 - 991

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Interpolation

26% 27%

+2,654 -11,343

Q. Where on the line does 0 fall?

From + 2654 0 = 2654 = .1896 or 18.96% of distance

13997

Since distance = 27-26 = 1% = .1896 of 1%

Answer = 26 + .1896 = 26.19%

13,997

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Test @ 26.19%

Yr CF PVIF PV

0 - 1,000,000 1.0000 -1,000,000

1 500,000 .7924558 396,228

2 500,000 .6279862 313,993

3 500,000 .4976513 248,826

4 500,000 .3943667 197,183

5 - 500,000 .3125182 - 156,259

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Comparison of NPV vs. IRR

1. NPV accepts all projects with NPV > 0. Ranking of projects is by value of NPV.2. IRR finds the value of the discount rate that makes NPV = 0. Project will be accepted if IRR > k (cost of capital)

The big Q?Will the two methods always give the same answer?

No, unfortunately not

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The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of

capital of 10%, the project has a positive NPV of $100 million.

Capital Investment Decision

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Yr CF PV@10% PV@20%1 400 363.6 333.32 400 330.4 277.763 - 1,000 - 751.0 - 578.70

- 57 32.4IRR = 15.8%

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Reinvestment Rate AssumptionProject Yr0 Yr1 Yr2 Yr3 C of K NPV IRRX -10,000 5,000 5,000 5,000 10% 2,430 23.4%Y -10,000 0 0 17,280 10% 2,977 20.0%

IllustrationReinvestment@23.4% End Yr 1 End Yr 2 End Yr 3

5,000 6,170 7,6135,000 6,170

5,000 18,783

@ 10% 5,000 5,500 6,0505,000 5,500

5,000 16,550

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Value Additivity

Project NPV @10% IRR%

1 354 134.5

2 104 125.0

3 309 350.0

1 + 3 663 212.8

2 + 3 413 237.5

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Multiple Rates of Return

• Multiple Rates of Return NPV400

200 IRR 15%

Discount Rate 0 IRR – 12%- 200 - 400

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NPV Vs IRR

Conclusion

NPV is the correct method to use

But - there are some additional issues

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Other Issues

• Scale How do we evaluate between projects of

different scale?Project Outlay PV @ 10 % NPVA - 400 572 172B - 500 683 183How do we compare?If we have plenty of capital then it is not a problem.Both have a positive NPV so do both.

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Other IssuesScale

• Suppose we only have 600 worth of capital. Which project should we take?

• Work out the Profitability Index Present Value = PI Cost• Project A = 572 = 1.43 400 Project B = 683 = 1.37 500

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Other IssuesScale

• Now work out the weighted PI• For A (1.43 x 400) + (1 x 200) = 1.2866 600 600 .9533 .3333

For B (1.37 x 500) + (1 x 100) = 1.3084 600 600Therefore take Project B

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Other IssuesProject Lives

• What if projects take place over different time scales?

Yr Project A Project B 0 - 17,500 -17,500 1 10,500 7,000 2 10,500 7,000 3 8,313NPV @ 10% 723 894

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Other IssuesProject Lives

• How to choose• Assume you are able to repeat the projects

until they have the same end date 0 2 4 6 A 3 B

723597 723 (discount at 10%)598 723 (discount at 10%)1813

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Project Lives

0 2 4 6

3

894

672 894 (discount at 10%)

1566

• Project B

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Project Lives

• This approach is fine for simple project lives but what if they are complex?

• E.g.lives of 7 years, 9 years and 13 years

• Answer make them all last for ever!

• NPV(n, to inf) = NPVn (1+ k)n

(1+ k)n – 1

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Project Lives

• E.g. NPV2 to inf = 723 (1.1)2 = 723 x 1.21

(1.1)2 - 1 .21

723 x 5.76 = 4,165

NPV3 to inf = 894 (1.1)3 = 894 x 1.331

• (1.1)3 – 1 .331

894 x 4.02 = 3,596

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Cash Flows

Example –

Consider the following new project:-

Initial capital investment of £15m.

It will generate sales for 5 years.

Variable Costs equal 70% of sales.

Fixed cost of project =£200,000 P.A.

A feasibility study, cost £5,000 has already been carried out.

Discount rate = 12%.

Should we take the project?

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Cash Flows£000's 2000 2001 2002 2003 2004 2005 SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000

CASHFLOWS -15000 4000 4600 5200 5800 6400 11000

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

NPV -15000 3571 3667 3701 3686 3632 3257

19.75 1.00 0.84 0.70 0.58 0.49 0.41

IRR = 19.75% -15000 3340 3208 3028 2820 2599 -4

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Cash Flows

Treatment of depreciation in NPV analysis.

-We only use cashflows in investment appraisal.

-Depreciation is not a cashflow.

-However, depreciation (capital allowances) is allowable against tax (see income statement), which affects cashflow.

For cashflow, add depreciation back:-

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Treatment of Depreciation£000's 2000 2001 2002 2003 2004 2005 SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000DEPRECIATION -3000 -3000 -3000 -3000 -3000NOI -15000 1000 1600 2200 2800 3400 11000NOI AFTER TAX 800 1280 1760 2240 2720 8800ADD BACK DEPN (= NCF) 3800 4280 4760 5240 5720 23800

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567 -15000 3393 3412 3388 3330 3246 1769

NPV -15000 3266 3162 3022 2859 2683 -8DF 16.35 1.00 0.86 0.74 0.63 0.55 0.47

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Issues to ConsiderCash Flows

• But not in detail!

• Cash flows should be incremental

- include all incidental effects (redundancy)

- Do not forget working capital

- Do forget sunk costs!

- Be careful with allocated overheads

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Issues to ConsiderCash Flows

• ‘Uncertainty means more things can happen than will happen’ Brealy and Myers.

• How do we obtain a feel for what the cash flows are most likely to be?

• - Sensitivity Analysis• - Scenario Analysis• - Break Even Analysis• - Simulation

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Issues to ConsiderCash Flows Sensitivity Analysis

• Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet

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Issues to ConsiderCash FlowsSensitivity

Figure 7.1 HomeNet’s NPV Under Best- and Worst-Case Parameter Assumptions

Green bars show the change in NPV under the best-case assumption for each parameter; red bars show the change under the worst-case assumption. Also shown are the break-even levels for each parameter. Under the initial assumptions, HomeNet’s NPV is $5.0 million.

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Issues to Consider Cash Flows

Scenario Analysis

Table 7.10 Scenario Analysis of Alternative Pricing Strategies

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Figure 7.2 Price and Volume Combinations for HomeNet with Equivalent NPV

Capital Investment Decision

The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher NPV and are superior.

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Issues to ConsiderCash Flows

• Break even analysis

Using the IRR to give a feel for the ‘margin of safety’ ref the cost of capital

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Issues to ConsiderDiscount Rate

• We also need to consider what discount rate to use as this will also effect the outcome.

• This is the next subject