When projects we undertake deliver cash flows in which the discounted value is expected to exceed the cash used to finance the endeavor, Quaker’s economic value increases and shareholders are the immediate beneficiaries. In short, good management decisions result in stock price appreciation.

The Quaker Oats Company, 1992 Annual Report.

Capital Budgeting

• Generating investment proposals

• Estimating future cashflows

• Evaluating the project cashflows to select projects

• Reevaluating implemented projects continually

Investment Projects

• Investment in new products

New areas of business/ new markets

• Expansion of existing projects

• Acquisitions

• Replacement of equipments/ buildings

• Changes in the way business is run

• Research and development

• Others – Safety related. Pollution control

Pay Back Period

• Number of years in which the original investment in a project is recovered.

• A cut off period decided to accept / reject a proposal.

Expected Cash Flows for Projects

Year A B C

0 -100 -100 -100

1 20 50 50

2 30 30 30

3 50 20 20

4 60 60 60,000

Payback period (years)

3 3 3

Evaluation of Payback Period

• Timing of cash flows within the payback period ignored.

• Payments after the payback period is ignored.

• Arbitrary standard for payback period.

• Intuitively appealing and easy to calculate.

• Used for making small value decisions.

• Useful for growing companies with limited cashflow.

Discounted Payback Period Method

• Time taken for discounted cash inflows to equal initial investment.

• Takes care of one of the weaknesses.

• Loses simplicity.

Average Accounting Return

Average post tax earnings as a percentage of average investment (Book value).

-Uses Accounting figures and not cash flows.

-Timing of cash flows ignored.

-Easy to calculate.

-Readily available accounting numbers.

Net Present Value Method

Calculates the present value of the expected cash flows at an appropriate discount rate and subtracts from it the initial investment in the project.

If the net present value is positive, the project is accepted.

If negative the project is rejected.

NPV = {C1/(1+r)1 + C2/(1+r)2 +…+ Cn/(1+r)n} – C

= {C1(PVIFr * 1) + C2(PVIFr * 2)+…+ Cn(PVIFr * n)} – C

The project’s initial cash outlay is Rs. 35,000. At the end of the first year, an additional Rs. 1000 cash investment in net working capital (Current assets less current liabilities associated with the project) must be made. At the end of the project’s life, this Rs. 1000 net working capital will be recovered. Project is expected to generate after-tax operating cash inflows of Rs. 10,000 in year 1; Rs. 12,000 in year 2; Rs. 14,000 in year 3 ; and Rs. 15,000 in year 4.

Project Cash Flows and NPV Calculation for Project M

Time T (years) 0 1 2 3 4

Initial Cost, C0 -35000

Changes in net Working capital

-1000 1000

Cash inflows, CF1 10000 12000 14000 15000

Net cash flows -35000 9000 12000 14000 16000

Present Value of cash flow (12%)

-35000 8036 9566 9965 10168

NPV = -35000 + 8036 + 9566 + 9965 + 10168 = 2735

Net Present value• Net present values are additive

Value of a firm = PV of projects in place + NPV of expected future projects

• Value of Assets in place and value of expected future growth.

• Termination of a project : impact on value

• Divestment of asset

• Acquisition

Internal Rate of Return (IRR)

• The rate that makes the NPV of the project zero.

• Compares IRR with cost of capital of the company.

• NPV ={C1/(1+r)1 + C2/(1+r)2 +…+ Cn/(1+r)n} – C=0

• Iterative process

Consider a project with an initial cash outflow, C0 equal to Rs. 30000 and cash inflows in year 1 of Rs. 11800 and year 2 of 27847. Find the IRR of the project.

Discounted at

Year Cash flow 16% 18% 20%

0 -30000 -30000 -30000 -30000

1 11000 10173 10000 9833

2 27847 20695 20000 19338

NPV 868 0 -822

Internal Rate of Return (IRR)

• The IRR is internal or intrinsic to the project and depends only on the cash flows.

• Closest to the NPV method. IRR > COC NPV is positive. IRR < COC NPV is negative. Therefore in general, the two methods are

complementaryThe hurdle rate

Our criterion of acceptance is simple.New investments are expected to provide cash returns that exceed our long term, after tax, weighted average cost of capital, currently estimated at approximately 11 percent.

Coca Cola Annual Report, 1998

NPV vs IRR

1. Multiple Rates of Return

2. Mutually Exclusive Projects

- Timing of Cash Flows

- Project Size

- Life of the Project

Multiple Rates of Return 0 = C1 / (1 + r)1 + C2/ (1+r)2 +…+ Cn/(1+r)n - C

- Negative flow during or at the end of the project.

(-100, 230, -132)

IRR = 10% and 20%.

No Feasible IRR

• +1000

• -3000

• +2500

• NPV at 10% = +339

• IRR ?

Purchase price of Copper Mine = Rs. 500000 Cost of Capital = 10% Life = 1 year

Plan S

Purchase cost of Fleet = Rs. 500000

Net Cash flows = Rs. 1280000

Plan L

Installation Cost of Conveyor Belt = Rs. 4500000

Net Cash flow = Rs. 6000000

Net Present Value

Project S Cost of the Project = Rs. 500000 + Rs. 500000 = Rs. 1000000

NPV = 1280000 (PVIF10%, 1year) – 1000000 = 1280000 (0.9091) – 1000000 = 163648.Project LCost of the Project = Rs. 500000 + Rs. 4500000 = Rs. 5000000

NPV = 6000000 (PVIF10%, 1year) – 5000000 = 6000000 (0.9091) – 5000000 = Rs. 454600.

Internal Rate of Return Project S

Rs. 1280000 * (PVIFr, 1) – 1000000 = 0

PVIFr, 1 = 0.78123

IRRs = 28%

Project L

Rs. 6000000 (PVIFr, 1) – 5000000 = 0

PVIFr, 1 = 0.8333

IRRL = 20%

• IRR NPV

• Project S 28% 163648

• Project L 20% 454600

Different Project Lives

Year Project X ProjectY

0 -1000 -1000

1 0 +2000

2 0 0

3 3375 0

• IRR NPV

• Project X 50% 1536

• Project Y 100% 818

Cash Flow

Years 0 1 2 3 NPV IRR

Project E

(65000) (40000) (30000) (20000) 11783 20.89%

Project L

(65000) 104000 13136 16.96%

The use of the NPV method to compare projects implicitly assumes that the opportunity exists to reinvest the cash flows generated by a project at the cost of capital, while use of the IRR method implies the opportunity to reinvest at the IRR.

Modified Internal Rate of Return

Future value at the end of the project of all cash flows (except initial investment) at the cost of capital.

FVE = (40000)(FVIF10,2) + (30000)(FVIF10,1)+ 20000 = 101400.

MIRR:-

65000 = 101400 / PVIFMIRR,3

= 15.98%.

The Profitability Index• Ratio of the present value of the expected cash

flows after the initial investment divided by the initial investment.

• PI = PV of Cash Flows subsequent

to initial Investment / Initial Investment

• Useful under capital rationing.

Capital Rationing (65000)

• Project Initial cash IRR NPV PI• A 50000 15% 12000 1.24• B 35000 19 15000 1.43• C 30000 28 42000 2.40• D 25000 26 1000 1.04• E 15000 20 10000 1.67• F 10000 37 11000 2.10• G 10000 25 13000 2.30• H 1000 18 100 1.10

Project Combinations

• Feasible NPV

• F,C,D 54000

• C,B 57000

• C,G,F,E 76000

NPV versus IRR

• Assumption of reinvestment rate

• Multiple rates of return

• Accounting for difference in size and life

• Calculation of value addition to the company

• Easier to visualise and interpret.

• No need to initially calculate required rate of return

• Margin of safety

Margin of Safety

• Costs Return NPV(10%)

• Project S 10000 16500 5000

• Project L 100000 115500 5000

Internal Rate of Return

• Reinvestment assumption

• Size and duration of the project

• Finance projects only with the highest IRRs

Evaluation of Capital Budgeting Methods

• NPV is the single most important method. Rupee benefit of the project to shareholders. Increase in value.• Payback : Liquidity, Risk and Growth firms• IRR : Safety Margin• PI : Bang for the Buck Project Risk estimation.•

Capital Budgeting Practices

• Popularity of accounting measures

• IRR more popular than NPV, although significant shift towards NPV

• Payback period as the primary investment rule

• Use of more than one measure in decision making

When projects we undertake deliver cash flows in which the discounted value is expected to exceed the cash used to finance the endeavor, Quaker’s economic value increases and shareholders are the immediate beneficiaries. In short, good management decisions result in stock price appreciation.

The Quaker Oats Company, 1992 Annual Report.

Strong cash flow over the long term is [Quakers managers’] primary objective. Thus, along with management judgment, cash flow analysis is the critical yardstick used in allocating corporate resources.

It takes investments in fixed and working capital to support a profitable and growing business… initially these investments may inhibit cash flow but are absolutely essential for building future profitable growth.

The market evaluates the Company’s ability to invest in projects that generate superior cash flows, and shareholders reap the benefits of greater stock price appreciation.

Estimating Cashflows

• Experience of similar projects

• Test marketing

• Scenario analysis

Basic Principles

1. Cash flow Principle

2. Incremental Principle

3. Interest Exclusion Principle

4. Post tax Principle

Cashflows• Cash flows matter—not accounting

earnings.• Initial outflow• Operating cashflows• Terminal cashflows• Consider depreciation expense. • Much of the work in evaluating a project

lies in taking accounting numbers and generating cash flows.

Free Cashflows

• EBIT (1-t)

• Depreciation and non cash charges

• Changes in working capital

• Capital expenditures

Incremental Cash Flows

• Sunk costs don’t matter.

• Incremental cash flows matter.

• Opportunity costs matter.

• Side effects like cannibalism matter.

• Taxes matter: we want incremental after-tax cash flows.

• Inflation matters.

• When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs.

Incremental Cash Flows

• Side effects matter.– Cannibalism is bad. If our new product

causes existing customers to demand less of current products, we need to recognize that.

After Tax Principle

• Cashflows (operating profits) net of taxes

• Impact of depreciation, capital gains on asset disposal

• Post tax cost of capital

• Pre tax Cost of capital and cashflows. Consistency in treatment

Interest Inclusion

• Separation of operating and financing cashflows

• Interest cost already included in cost of capital

• Cashflows available to all providers of capital

A lathe for trimming molded plastics was purchased 10 years ago at a cost of Rs. 7500. The machine had an expected life of 15 years at the time it was purchased, and management originally estimated, and still believes, that the salvage value will be zero at the end of the 15-year life. The machine is being depreciated on a straight line basis; therefore, its annual depreciation charge is Rs. 500, and its present book value is Rs.2500. The R& D manager reports that a new special-purpose machine can be purchased for Rs. 12000 (including freight and installation), and, over its five-year life, it will reduce labor and raw materials usage sufficiently to cut annual operating costs

form Rs. 7000 to Rs.4000. It is estimated that the new machine can be sold for Rs. 2000 at the end of five years; this is its estimated salvage value. The old machine’s actual current market value is Rs. 1000, which is below its Rs. 2500 book value. If the new machine is acquired, the old lathe will be sold to another company rather than exchanged for the new machine. The company’s corporate tax rate is 40 percent, and the replacement project is assumed to be of average risk. Net working capital requirements will also increase by Rs. 1000 at

the time of replacement.

Initial Operating Terminal

C1 C2 C3 C4 C5

Old M/C 1000CG (1500)Tax Ben 600New M/C (12000)Incr WC (1000)Oper Sav 3000After tax 1800Dep New 2000Tax sav 800Dep Old 500Tax loss (200)Salvage 2000Rec WC 1000Total (11400) 2400 2400 2400 2400 5400

Risk Analysis in Capital Budgeting

If anything can go wrong, it will.

Murphy’s law

At the worst possible time.

O’Reilly

Why Risk Analysis

• Project Value Drivers

Sensitive Parameters

• Resolving the Uncertainty

• Real Options

Tools of Risk Analysis

• Payback

• Risk adjusted Discount Rate

• Certainty Equivalent

• Sensitivity Analysis

• Scenario Analysis

• Breakeven Analysis

• Monte Carlo Simulation

Payback

• Focus on liquidity

• Shorter term projects

Establish maximum payback period.

Time Value of money

Post payback cashflows

Risk adjusted Discount Rate

• Incorporate risk premium in discount rate to evaluate the project.

• COC vis a vis risk adjusted discount rate.

Certainty Equivalent

• Change in cashflows to reflect risk

• Certainty equivalent coefficient

Variability of outcomes

Attitude towards risk

Varying certainty coefficients

Sensitivity Analysis

• Impact on NPV due to change in variables

Identification of the impacting variables.

Establishing the mathematical relationship.

Analysis of the impact of changes.

Optimistic. Expected. Pessimistic situations.

Scenario Analysis

• Change in variables due to change in the underlying scenario. Factor around which the scenario will be built.

• More realistic and conceptually correct due to interdependence of variables

• Best. Normal. Worst scenario.

Breakeven Analysis

• How bad can sales get before we start losing money

• Accounting vs cash breakeven

• Importance of the cost structure : fixed vis a vis variable cost.

Monte Carlo Simulation

• All possible combinations. Entire distribution of project outcomes.

• David Hertz & McKinsey

• Model the cashflows

• Specify probabilities

• Simulate the cashflows

• Calculate present values

Risk Adjustment Practices

• Technique Percentage

• No adjustment 14%

• Subjective 48

• Certainty equivalent 7

• Risk adjusted discount rate 29

• Shortening payback period 7

• Others 5

Capital Budgeting under Inflation

• Nominal discount rate vis a vis real cashflows. Consistency in treatment.

• Price and costs respond differently to inflation.

• Required return on investment

• Nominal rate = (1+real ) (1+inflation) – 1

Key Concepts

• Managers increase existing shareholder’s wealth by making positive net present value decisions.

• After-tax cash flows are used for evaluating investment projects.

• Net present value is superior for a number of reasons to alternative capital budgeting methods.

Key Concepts cont…

• If two projects are mutually exclusive, the one with the higher net present value is chosen.

• The increase in the value of the firm from its capital budget for the year is the sum of NPVs of all accepted projects.