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Chapter 9
CAPITALBUDGETING
PROCESS
Alex Tajirian
Capital Budgeting Process 9-2
© morevalue.com, 1997
1. INTRODUCTION
# Working with the left-hand-side of a balance sheet
# CAPITAL BUDGETING //INVESTING in Long-term Assets! Definitions
" Capital: Fixed assets used in production
" Budget: Plan of in- and outflows during some period
" Capital Budget: A list of planned investment (i.e.,expenditures on fixed assets)outlays for different projects.
" Capital Budgeting: Process of selecting viableinvestment projects.
" Financial investment vs. economic investment
! In this course, investments are needed in order to:
" Expand in existing markets.
" Enter new markets.
" Replace existing capital assets.
Alex Tajirian
Capital Budgeting Process 9-3
© morevalue.com, 1997
! Where do these projects come from?
" Suggested by managers of plants & divisions
" Upper management
! Upper management approves these projects
! Investment and financing decisions are independent.
! Some common errors:" Expansion without incorporating cost of financing " Cost cutting without looking at revenue side" Ignoring alternative uses of capital
# TOOLS CAN BE USED IN:
! M&As
! Divestitures & spin-offs
! Correct-sizing
! Other
Alex Tajirian
Capital Budgeting Process 9-4
© morevalue.com, 1997
# CAPITAL BUDGETING OUTLINE
! Develop tools & criteria of selecting projects (Ch. 8): GivenQ Relevant CFsQ The required return of the project (i.e., the risk of use of
project CFs)
! Determine which CFs are relevant in project analysis (Ch. 10)
! Introduce possibility of forecast error in CF data used inanalysis (Chapter 11)
! Assume that k (cost of financing) is known until Ch. 12
Alex Tajirian
Capital Budgeting Process 9-5
© morevalue.com, 1997
FINANCIAL MANAGEMENTPROCESS
Given yourLine of Business
List Potential Projects
External(M&A)
InternalExpansion
Divestitures & Spin Offs
Choose ViableProjects
Choose AppropriateFinancing
Optimal Dividend policy
Choose AppropriateWorking capital
Type of Business
Type ofProjects
Capital Budgeting
Capital Structure
Short-term financialManagement
Dividend Policy
Alex Tajirian
Capital Budgeting Process 9-6
© morevalue.com, 1997
CAPITAL BUDGETING &FINANCING
INVESTMENTDECISION
FINANCINGDECISION
Alex Tajirian
Capital Budgeting Process 9-7
© morevalue.com, 1997
CapitalBudgeting
Managerial &Entrepreneurial
Skills
MANAGERIAL TALENT &INVESTMENTS
Alex Tajirian
Capital Budgeting Process 9-8
© morevalue.com, 1997
2. TOOLS OF INVESTMENT DESIRABILITY
2.1 BASIC INTUITION(1) Criteria
How fast you re-coup initial investment?Benefits > CostsCompare PV of cash inflows & PV of cash expenditureCompare return on investment & cost of financing project
(2) A word of Caution
A manager needs to make a decision today (t=0) givenestimated/forecasted cash flows. Obviously there is noguarantee that the decision would always turn out asanticipated. However, what is important is that the managerhas to make the best decision at t=0 given all the relevantinformation.
2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS:
## Independent: A project that has nothing to do with other projectsunder investigation.
Example: Replace copy machine and build a new plant.
## Mutually Exclusive: You only need one of these alternativeprojects.
Example: Buy IBM or Apple PC?
Alex Tajirian
Capital Budgeting Process 9-9
© morevalue.com, 1997
2.3 TOOLS
3.1 Payback Period Method:
Criterion: For two mutually exclusive projects, choose the one thatpays you back your initial cost the sooner.
Example: Calculating Payback Period
Given the following CFs, and k = 10%, we get:
Investment Initial cost CF1 CF2
A $10,000 0 $14,400
B 10,000 $10,000 2,400
ˆ choose project B, since it pays back initial investment in oneyear.
? Is this choice optimal?
Alex Tajirian
Capital Budgeting Process 9-10
© morevalue.com, 1997
ˆ NPV ' PV of all Relevent CFs & Initial Investment
'CF1
(1%k)1%
CF2
(1%k)2% ...%
CFn
(1%k)n& I0
' jn
t'1
CFt
(1%k)t& I0
' jn
t'0
CFt
(1%k)t
' CF1[PVIFk,1] % CF2[PVIFk,2] % ... % CFn[PVIFk,n] & I0
3.2 Net Present Value (NPV) method:
L Payback ignores the concept of CFs. Ignores CF after paybackand risk of CFs.
ˆ̂ we need to look at the PV of these CFs net of any initial cost.
where,CFt / Net cash flow (inflow - outflow) at time t I0 / Initial cost or investment outlaysk / cost of capital (financing) / required return reflecting risk of use of CFs
Note: CF0 / I0
Alex Tajirian
Capital Budgeting Process 9-11
© morevalue.com, 1997
NPV measures the additional market value thatmanagement expects the project to create (or destroy) ifit is undertaken.
Independent Projects : Choose All Projects with NPV > 0.
Mutually Exclusive: Choose projects with the highestNPV.
Thus,
NPV Criteria:
Since the objective of the manager is to maximize value, then for
Note: NPV > 0 is equivalent to PV of cash inflow > PV of cashoutflow.
Alex Tajirian
Capital Budgeting Process 9-12
© morevalue.com, 1997
NPVA '$14,400
(1%k)2& 10,000 ' $1,901
NPVB '10,000
(1%.1)1%
2,400
(1%.1)2&10,000 ' $1,074
Example: Calculating NPV
Given the following CFs, and k = 10%, we get:
Investment Initial cost CF1 CF2
A $10,000 0 $14,400
B 10,000 $10,000 2,400
Solution:
ˆ̂ choose A, since it has the highest NPV if mutually exclusive,or both if independent as they are both with NPV >0.
Alex Tajirian
Capital Budgeting Process 9-13
© morevalue.com, 1997
Remarks on payback method:With payback method, project B is selected. Thus, if you ignoreamount, timing, and risk of CFs, then potentially you would end upwith the wrong valuation.
Both projects would add value to shareholders. However, if youselect project "B", you would not be maximizing shareholder value,as "A" provides more value to shareholders.
In general, if you accept a project with NPV <0, then you aredestroying shareholder value!
Alex Tajirian
Capital Budgeting Process 9-14
© morevalue.com, 1997
Value created per share 'NPV
# of shares outstanding
'$1,9011,000
' $1.901
Example: Calculating additional Shareholder Value
Using a project's NPV = $1,901 and assuming that there are 1,000 sharesoutstanding, then
Y If the project is adopted then the price of the stock should increase by$1.90.
Alex Tajirian
Capital Budgeting Process 9-15
© morevalue.com, 1997
ROI 'profit
investment
3.3 Internal Rate of Return Method (IRR)
# Motivation:! “Internal” in that it is a rate of return that depends on the CFs
of the project.
! Return on investment (ROI) is a very intuitively appealingconcept; measured in % terms.
! Easy to determine profit if you have single CF in future. Whatabout if we have multi-period payoffs?
Periods
0 1 2 3
CF from project -100 10 60 80
Profit would be calculated as:Ending Value - Beginning Value = $80 - $100
But this calculation ignores the intermediate CFs, namely $10and $60 in periods 1 and 2 respectively.
Alex Tajirian
Capital Budgeting Process 9-16
© morevalue.com, 1997
NPV ' 0 ' CF0 %CF1
(1 % IRR)%
CF2
(1 % IRR)2% ... %
CFN
(1 % IRR)N
IRR Criterion: Choose projects with IRR higher than cost offinancing.
Thus, when examining the return on a project, we need anew tool that would incorporate all the cash flows of aproject.
# Definition of IRR : IRR is defined as that particular k, such thatthe project breaks-even, i.e., when NPV = 0.Thus,
Decision Rule:
L If [the cost of financing "k"] < IRR Y NPV > 0 Y Additionalvalue would be created. Obviously the larger the difference betweenk & IRR, the higher the NPV.
Note: Use IRR cautiously for mutually exclusive projects!Limitations of IRR are discussed on p. 21.
Alex Tajirian
Capital Budgeting Process 9-17
© morevalue.com, 1997
&100 %300
(1%IRR)' 0
Y 300(1%IRR)
' 100
Y 100(1%IRR) ' 300
Y 100 % 100IRR ' 300
Y IRR '300&100
100'
200100
' 2 ' 200%
ROI '$300 & $100
$100' 200%
Example: Calculating IRR (single future CF)
Given:
Period CF($)
0 -100
1 300
Solution:
The ROI is:
Alex Tajirian
Capital Budgeting Process 9-18
© morevalue.com, 1997
Example: Calculating IRR (multiple future CFs)
Given:
Periods
0 1 2 3
CF from project F -100 10 60 80
IRRF = ?
Alex Tajirian
Capital Budgeting Process 9-19
© morevalue.com, 1997
CF0 %CF1
(1% IRR)%
CF2
(1% IRR)2% ... %
CFN
(1% IRR)N' 0
&100 %10
(1% .19)%
60
(1% .19)2%
80
(1% .19)3< 0
&100 %10
(1% .17)%
60
(1% .17)2%
80
(1% .17)3> 0
Solution:
L To calculate IRR (just like YTM) there is no simple formula touse. Thus, we need to use either trial & error method or acalculator. From definition of IRR,
! Guess an IRR, say IRR = 19%, then substituting in above equationyields:
! You have guessed a number too high. Try a smaller #, say IRR =17%, thus
ˆ̂ If you try IRR = 18.1%, you get correct answer.
IRRF = 18.1% (using either trial & error or calculator)
Alex Tajirian
Capital Budgeting Process 9-20
© morevalue.com, 1997
NPV Flow Profile: Relation between NPV, IRR, and "k"
Alex Tajirian
Capital Budgeting Process 9-21
© morevalue.com, 1997
Problems With IRR for Mutually Exclusive Projects:
Problem 1: Consider two projects such that returnA = 15%, returnB =50%, and k = 10%. Which would you choose?
Now assume that they require the following initial investments:IA = $1,000,000 while IB = $100
? Which would you choose?
ˆ̂ If initial investments are not equal, IRR ranking can bemisleading.
Problem 2: Possible existence of multiple IRRs. Every time the CFschange sign, you would get an additional IRR. (See NPV,IRR, "k" profile)
Problem 3: Possible conflict of ranking with NPV.
Alex Tajirian
Capital Budgeting Process 9-22
© morevalue.com, 1997
AROR ' Accounting Rate of Return
'
jt'1
accounting profit after tax t /N
(initial outlays % salvage value)/2
3.4 What tools does industry use?
Tool % use of eachTool
Primary method
NPV 21%
IRR 49
payback 19
AROR 8
Secondary method
NPV 24%
IRR 15
payback 35
AROR 19
where t is time, and N = # of periods
Source: Kim, Crick, and Kim, "Do executives Practice What Academics Preach?"Management Accounting (November 1986), pp. 49-52.
Alex Tajirian
Capital Budgeting Process 9-23
© morevalue.com, 1997
So Why Does Industry Still use IRR Despite Problems?
< percentage results are more intuitive than a $NPV; 50% return vs.NPV = $500,000
< Since IRR gives you break-even cost of financing:The number itself is of interest to managers; you want simplyto ask at what financing cost does project break-even?
< If a project's break-even is 100%, in a "normal" situation, youwouldn't need to go through the trouble of estimating all the CFs, as100% is considerably higher than a “normal” financing rate.
? Why Do Managers Use Payback with All of itsProblems?
Alex Tajirian
Capital Budgeting Process 9-24
© morevalue.com, 1997
3. SUMMARY
T Payback Period
T NPV
# Independent Projects
# Mutually exclusive
# NPV = sum of discounted CFs, where the discount rate isthe cost of financing the project.
# NPV criterion is equivalent to PV of cash inflow > PV ofcash outflow
T IRR
# CriterionTwo equivalent ways to look at it
Break-even or ROI > cost of financing project
# Calculation ! Trial & error ! Calculator
Alex Tajirian
Capital Budgeting Process 9-25
© morevalue.com, 1997
4. QUESTIONS I. True/Disagree-Explain
1. According to the NPV criterion, you should choose all projects with NPV > 0.
2. According to the IRR criterion, you should choose projects with IRR < cost of financing.
3. Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction.
4. Capital budgeting tools can be used to analyze the merits of "flextime."
5. A NPV > 0 project might not be undertaken because of its high risk, despite the manager'sconfidence in the accuracy of the CF estimates.
6. If a company is expanding, then it is necessarily creating additional value to shareholders.
7. If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor'sprofits would be zero.
II. Problems1) Given:
Project S Project L
Cost $10,000 25,000
Annual Benefits $4,000 8,000
# of years 5 5
k 14% 14%
Which of these mutually exclusive projects is better based on NPV and IRR?
Alex Tajirian
Capital Budgeting Process 9-26
© morevalue.com, 1997
ANSWERS TO QUESTIONS
I. Agree/Disagree-Explain
1. Disagree. Only if the projects are independent. If they are mutually exclusive, then youchoose the one with the highest NPV.
2. Disagree. If IRR < cost of financing, then the project would be losing money as it costs moreto finance than to break-even. Such a project will have NPV < 0.
3. Agree. NPV = -market price + PV of dividends. Present value of a stock would be its Agreeworth--value. If you pay (market price) exactly its worth (PV of dividends), then NPV = 0.
4. Agree. Analyzing flextime corresponds to analyzing its impact on a firm's CFs. However, inpractice it is difficult to obtain good estimates of the incremental CFs. Thus, if "flextime"makes sense, then you would be undertaking a NPV > 0 project.
5. Disagree. The risk of CFs is reflected in the cost of capital (k). Thus, the fact that you obtaina NPV > 0, and assuming you did the correct calculation, the project should be accepted.
6. Disagree. Only if it is re-investing revenue at a rate higher than the required rate of return.A simple example would be a company borrowing to finance projects that are not profitable,NPV <0. Thus, expansion does not necessarily translate into shareholder value creation.
7. Disagree. NPV = 0 implies that an investor is being compensated by an amount
commensurate with the risk and value of the investment, i.e. there are no excess profits.
Alex Tajirian
Capital Budgeting Process 9-27
© morevalue.com, 1997
II. Problems1)
Step 1 Are CFs of equal length? Yes
Step 2 Calculate NPVNPVS = -10,000 + 4,000(PVIFA14%,5) = 3,732NPVL = -25,000 + 8,000(PVIFA14%,5) = 2,465
ˆ̂ L
S
Using IRR: IRRS = 28.6% and IRRL = 18%
Since cost of capital for each = 14% < IRR. Y Accept S as it has a higher IRR.Obviously, you should choose both if they were independent.
Alex Tajirian
Capital Budgeting Process 9-28
© morevalue.com, 1997
ELIMINATIONS
a. APPROACHES TO CAPITAL BUDGETING! Top Down Approach! Bottom up Approach
INTER-DEPENDENCE OF INVESTMENT &FINANCING DECISIONS
Illustration 1:
Project 1: ATT owes you $100, and makes you an offer of $100 today or$107 next year. Which would you choose? Assume that returnon similar risky investments is 6%.
Project 2: Suppose, in addition to the ATT opportunity, you have a "greatdeal" that requires a $100 investment that is expected to payoff$300 in a year.
Case 1: Assume: you can borrow at a cost of 10%. Action: Take both projects (independent)
Alex Tajirian
Capital Budgeting Process 9-29
© morevalue.com, 1997
PVATT '$107
(1 % .06)' 100.94 > $100 Y
NPVATT '&100 % 100.94 ' $.94
ˆ choose $107 as
PVATT '1.06
NPVgreat deal ' &100 %300
' $172.7
Thus, if you borrow, in effect you would be undertaking bothprojects.
ˆ̂ Total NPVindependent = NPVATT + NPVgreat deal
= 0.94 + 172.7 = 173.64
Case 2: You cannot borrow, or cost of borrowing is 400% andassume that a project with same risk as "great deal" hasa return of 12%.
Action: Mutually exclusive projects
Alex Tajirian
Capital Budgeting Process 9-30
© morevalue.com, 1997
NPV"great deal" ' &100 %300
(1 % 4)
' &100 % 60 ' &40 < PVIRS
Alex Tajirian
Capital Budgeting Process 9-31
© morevalue.com, 1997
NPV ' &100 %300
1%.12' &100 % 267.8 ' 167.8 < NPVindependent
Obviously, in this case you are better off taking $100 from ATT. Thus, ˆ̂
Choose project with highest NPV Y choose "great deal".
Notes:! You discount at 12%, since it is the return you have to forego
if you invest in a project with same risk as ATT.! NPVindependent > NPVmutually exclusive
Alex Tajirian
Capital Budgeting Process 9-32
© morevalue.com, 1997
EPS1
k% NPVGO ..................................................
Let RR'Retention Ratio Y D1' (1&RR)(EPS
1)
Y return on retained earnings ' (RR)(EPS1)(ROE)
where ROE 'EPS
1
book equity per share
Y NPV1' &I
0% PV of increases CFs
' &(RR)(EPS1) %
(RR)(EPS1)(ROE)
k
' (RR)(EPS1) &1 %ROEk
. . . .......((()
Y NPV1, NPV
2,.... are growing at a rate (RR)(ROE) ' g
Y NPVGO 'NPV
1
k & g
ˆ p0'
EPS1
k%
NPV1
k & g'
D1
k & g
b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV
p0 = PV (CF of existing business) + NPV ( dividend growth due toinvestment of future earnings)
Substitute NPVGO in (*), we get
Conclusions: NPVGO depends ona. EPS1: current earnings size
Alex Tajirian
Capital Budgeting Process 9-33
© morevalue.com, 1997
b. RRc. Relative magnitudes of ROE and k; see equation (**) above.d. Growth, (RR)(ROE), does not necessarily imply NPV _.
Alex Tajirian
Capital Budgeting Process 9-34
© morevalue.com, 1997
c. WHERE DO NPV> 0 PROJECTS COME FROM?
# In long-run NPV = 0 ] excess economic profit = 0
# Sources of NPV > 0 (Sources of competitive advantage)! Barriers to entry! product differentiation! economies of scale! better distribution channels! luck
INVESTMENT UNDER UNCERTAINTY
Classical micro-economic theory
Observations:# Firms use cost of capital "hurdle rate" in NPV > 3 times cost of
capital ] firms invest only if price is substantially > LRAC(Summers '87)
# Firms stay in business even after p < AVC
# First quarter of '85 $ started `. By end of '87, $ was at '78 level.But, import volume did not ` until 2 years later. (Krugman &Baldwin '87)
Alex Tajirian
Capital Budgeting Process 9-35
© morevalue.com, 1997
# U.S. firms abandon project earlier than Japanese (TV, VCR, semi-conductors)
Explanation:Agree NPV = NPV + flexibility option
Sources of option value:# sunk costs in abandonment decision
! Severance pay for workers (-)! scarp value (+) (Myers & Majd '85)
" capital used is industry specific (eg. steel mills) Y Whois going to buy machinery when entire industry issuffering?!
" lemon problem" stop and re-start needs additional costs (McDonald &
Siegel '85)
# Uncertainty: product price, operating costs, interest rates Y value in option to wait (Pindyck '91, Ross & Ingersoll '92)! parameters:
" if uncertainly is high Y value of waiting _" if k is low Y future outcomes valued more Y value of
option to wait and resolve future uncertainty _." What happens if there are other firms in industry? Y
"balance" between waiting and implementing(Fudenburg & Tirole '83, Stiglitz '89)
" if k ` does not Y Investment _ as cost of waiting `" Why did U.S. abandon color TVs, VCRs and semi-
conductors?The value of waiting to invest is governed bydownside risk. But Japanese government supports
Alex Tajirian
Capital Budgeting Process 9-36
© morevalue.com, 1997
firms during downside through cartelization toavoid destructive competition. (Bernake '83)
! Sequential investing , as in drug industry
## Remarks! If 400% (in above illustration) is the cost of borrowing, maybe
that is the Agree cost of financing.! If a project sounds "too good to be Agree," it probably is "too
good to be Agree."! Role of market in information processing vs. personal
borrowing market.
Alex Tajirian