11W-Ch 10&11 Capital Budget Basics & CF estimation-2011-12-skraćeno

8/2/2019 11W-Ch 10&11 Capital Budget Basics & CF estimation-2011-12-skraeno

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10-1

CHAPTER 10 & 11The Basics of Capital Budgeting &Cash Flow Estimation

Should webuild this

plant?


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10-2

Capital Budgeting Overview Project Classifications

Analysis Methods/Decision Rules

Comparison of NPV & IRR

Optimal Capital Budget


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10-3

What is Capital Budgeting? Long-term Strategic Decisions

Analysis of Future Cash Flows

Large Expenditures (Fixed Assets)

Basis for Future Growth


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10-4

5 Steps to Capital Budgeting1. Estimate CFs (inflows & outflows)

2. Assess riskiness of CFs

3. Determine the Risk-adjusted Cost of Capital

4. Find NPV and/or IRR (and other methods)

5. Accept if NPV > 0 and/or IRR > WACC


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10-5

Project Classifications Replacement

Maintenance

Cost Reduction Expansion

Existing Products or Markets

New Products or Markets

Safety or Environmental

R&D (Long-term)

Long-term Contracts (Specific Customers)


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10-6

Major Capital Budgeting

Methods Payback ( + Discounted Payback)

Discounted Cash Flow (DCF or NPV)

Internal Rate of Return (IRR)

Profitability Index (not used in practice)

Modified Internal Rate of Return (MIRR)


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10-7

Independent vs Mutually

Exclusive Projects? Independent projects if the cash

flows of one are unaffected by the

acceptance of the other.

Mutually exclusive projects if the

cash flows of one can be adverselyimpacted by the acceptance of theother.


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10-8

Normal vs Nonnormal cash flow

streams? Normal streamNegative CF followed

by a series of positive CFs. 1 change

of sign Nonnormal stream Two or more

changes of sign Most common:

Negative CF followed by positive CFs,then negative CF to terminate

Nuclear Power, Toxic Waste


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10-9

Payback Method The number of years required to

recover a projects cost, or How longdoes it take to get our money back?

Calculated determining when thecumulative cash flow for the projectturns positive.


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10-10

Calculating Payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S


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10-11

Strengths & Weaknesses of

Payback Strengths

Provides an indication of a projects risk and

liquidity. Easy to calculate and understand.

Weaknesses Ignores the time value of money

Discounted Payback Alternative

Ignores CFs occurring after the payback


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10-12

Net Present Value (NPV)

Method Sum of the PVs ofALL cash inflows and

outflows of a project:

NPV = CFt/(1 + r)t + CF0

OR

n

0tt

t

)r1(

CFNPV


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10-13

Project Ls NPV, r=10% Year CFt PV of CFt

0 -100 -$100

1 10 9.09

2 60 49.59

3 80 60.11

NPVL = $18.79

NPVS = $19.98


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10-14

Rationale for NPVNPV= PV of inflows PV outflows (Cost)

= Net gain in Wealth

If projects are independent, accept if theproject NPV > 0

If projects are mutually exclusive, accept

projects with the highest positive NPV, Accept S if mutually exclusive (NPVs >

NPVL) & both if independent


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10-15

Internal Rate of Return (IRR)

Method IRR is the discount rate that forces PV of

inflows equal to costs. NPV = 0:

IRRL = 18.13% and IRRS = 23.56%.

n

0tt

t

)IRR1(

CF0


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10-16

Project IRR vs Bond YTM

Same Concept

YTM on the bond would be the IRR

of the bond project

EXAMPLE: Assume a 10-year bond

with a 9% annual coupon sells for$1,134.20.

Solve for IRR = YTM = 7.08%


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10-17

Rationale for IRR

If IRR > WACC, the Projects return

is greater than its costs.

There is excess Return left over to

boost stockholders returns.


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10-18

IRR Acceptance Criteria

If IRR > r, accept project.

If IRR < r, reject project.

If projects are independent, acceptboth projects, as IRR > r = 10%

If projects are mutually exclusive,accept S, because IRRs > IRRL.


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10-19

NPV Profiles

A graphical representation of project NPVs atvarious different costs of capital.

r NPVL NPVS0 $50 $405 33 29

10 19 2015 7 1220 (4) 5


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10-20

Drawing NPV profiles

-10

0

10

20

30

40

50

60

5 10 15 20 23.6

NPV($)

Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

SL

.

.

. ...

.

..

. .


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10-21

Main Reasons why NPV & IRRDecisions may Conflict

Reinvestment Rate Assumptions aredifferent

Size (scale) differences the smaller project freesup funds at t = 0 for investment. The higher theopportunity cost, the more valuable these funds,so high r favors small projects

Timing differences the project with fasterpayback provides more CF in early years forreinvestment. If r is high, early CF good, NPVS >NPVL.


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10-22

Reinvestment Rate Assumptions

NPV method assumes CFs are reinvested atr, the opportunity cost of capital.

IRR method assumes CFs are reinvested atIRR.

Assuming CFs are reinvested at the opportunity

cost of capital is more realistic, so NPV method isthe best.

NPV method should be used to choose betweenmutually exclusive projects.


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10-23

Profitability Index (PI)

PI is the Ratio of the PV of the CashInflows to the PV of Investment

PI = [ [CFinflowt/(1+r)t]] CFinvest0

PIL = $158.1/$100 = 1.581

PIs = $159.7/$100 = 1.597


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10-24

Theory says to accept all positive NPVprojects.

Two problems can occur when there isnot enough internally generated cash to

fund all positive NPV projects:An increasing Marginal Cost of Capital.

Capital Rationing

Optimal Capital Budget


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10-25

Externally raised capital can have largeflotation costs, which increase the cost

of capital.

Investors often perceive large capital

budgets as being risky, which drives upthe cost of capital.

Increasing Marginal Cost ofCapital


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10-26

Capital rationing occurs when acompany chooses not to fund allpositive NPV projects.

The company typically sets an upperlimit on the total amount of capitalexpenditures that it will make in theupcoming year.

Capital Rationing


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10-27

Cash Flow Estimation

Estimating Relevant Cash Flows

Adjusting for Inflation


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10-28

Relevant Project Cash Flows

2 Cardinal Rules Use Cash Flows NOT Accounting Income

Use Incremental After-tax Cash Flows Cash Flows Included

Opportunity Costs

Externalities Cash Flows NOT Included

Finance Costs

Sunk Costs


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10-29

Example Project Initial Investment

Depreciable Investment ($240,000)

Changes in Working Capital ($20,000)

Operations (no inflation)

New sales: 100,000 units/year @ $2/unit

Variable cost: 60% of sales

Life of the project

Economic life: 4 years

Depreciable life: MACRS 3-year class

Salvage value: $25,000

Tax rate: 40%

WACC: 10%


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10-30

Determining Project Value

Estimate relevant Cash Flows

0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4Invest +

TerminalCFs

NCF0 NCF1 NCF2 NCF3 NCF4


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10-31

Investment Cash Flows

Initial Investments (Depreciable Cost)

Equipment $200,000

Ship/Installation 40,000Net Investment CF0 $240,000

Change in Working Capital Inventories $25,000 (Asset)

Acct/Payables $5,000 (Liability)

NetNOWC $20,000


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10-32

Annual Depreciation Expense

Year Rate x Basis Depr1 0.33 x $240 $ 792 0.45 x 240 1083 0.15 x 240 364 0.07 x 240 17

1.00 $240

Due to the MACRS -year convention, a3-year asset is depreciated over 4 years.


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Annual Operating Cash Flows1 2 3 4

Revenues 200 200 200 200- Op. Costs (60%) -120 -120 -120 -120

- Depr Expense -79 -108 -36 -17Oper. Income (EBIT) 1 -28 44 63- Tax (40%) - -11 18 25Oper. Income (AT) 1 -17 26 38

+ Depr Expense 79 108 36 17Operating CF 80 91 62 55


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10-34

Terminal Cash Flow

Recovery of NOWC $20,000

Salvage value 25,000

Tax on SV (40%) -10,000

Terminal CF $35,000


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10-35

Estimated Project CFs (NoInflation)

IRR & NPV at WACC = 10%. NPV = -$4.01 million

IRR = 9.28%

Payback = 3.30 yrs

0 1 2 3 4

-260 80 91 62 55

+Terminal CF

3590

CCF -260 -180 -89 -27 63


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10-36

What if the expected AnnualInflation is 5%. Is NPV biased?

Yes, inflation included in the discountrate (WACC)

Inflation NOT included in CFs

CFs should be adjusted for Inflation


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10-37

Operating CFs, Inflation = 5%

1 2 3 4

Revenues 210 220 232 243Op. Costs (60%) -126 -132 -139 -146- Depr Expense -79 -108 -36 -17- Oper. Income (BT) 5 -20 57 80- Tax (40%) 2 -8 23 32

Oper. Income (AT)3 -12 34 48

+ Depr Expense 79 108 36 17Operating CF 82 96 70 65


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Estimated Project CFsadjusted for Inflation

0 1 2 3 4

-260 82 96 70 65

Terminal CF 35100

IRR & NPV at WACC = 10%. NPV = $14.78 million.

IRR = 12.56%.

Payback = 3.12 yrs

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11W-Ch 10&11 Capital Budget Basics & CF estimation-2011-12-skraćeno