Capital Budgeting is about allocating resources to competing uses

* Why resource allocation is important:

- Because resources are scarce

- Because a misallocation of resources can be fatal

* Range of decisions:

- Independent versus mutually exclusive projects

- Cost-minimizing versus profit-maximizing projects

* Sensible resource allocation requires an understanding of:

- Risk and how it affects project choice

- How returns from the project will be measured (earnings versus cash flows)

What is a project?

Any decision that requires the use of resources (financial or otherwise) is a project. This can range from:

* Broad strategic decisions

- Entering new areas of business

- Entering new markets

- Acquiring other companies

* Tactical decisions

- Opening a new branch

- Expanding an existing branch

* Management decisions

- The product mix to carry in a business

- The level of inventory to maintain

* Decisions on delivering a needed service

- Lease or buy a distribution system

- Creating and delivering a management information system

- Providing a training program to educate employees

Approaches to Investment Decision Making

Equity Approach: One approach focuses on the equity investor in the project and asks the question ñ Are the returns to equity investors high enough to justify taking this project?.

Firm Approach: The second approach expands the analysis to cover all investors in the firm - equity investors, lenders and preferred stockholders, if any. It asks a broader question - Are the total returns made by this project for all the investor groups high enough to justify taking this project?.

Approach Hurdle Rate Returns

Equity Approach Cost of Equity Returns to Equity Investors

Firm Approach Cost of Capital Returns to All Investors

Cost of Equity: What Equity Investors require as a rate of return for investing ...

Cost of Capital: What all investors (Equity Investors, Lenders) require as a rate of return for investing ...

Alternative Decision Rules

* Net income versus Cash Flow Based Rules

* Net Income versus Cash Flows

- Net income is based upon accounting rules; cash flows are based upon cash inflows and cash outflows.

- Net income is easier to manipulate than cash flows.

- There are cases where net income and cash flows give very different pictures of a project.

- When net income and cash flows conflict, cash flows are much more likely to reflect reality.

* Why net income is different from cash flows:

- Because depreciation, which reduces net income, is a non-cash charge.

- Because capital expenditures, which reduce cash flows, do not affect net income.

- Because working capital needs, which do not affect net income, can affect cash flows.

1. You have written a best-selling book, which Paramount Communications is planning to turn into a movie. You are negotiating your contract with Paramount, and they offer you two choices. Which of the two would you choose?
* 10% of net income on the movie
* 1% of the gross revenue on the movie

I. Accounting Measures

Return on Investment (ROI): This is the ratio of the firm's income to the book value of its assets. In project terms, this is the ratio of average after-tax income brought in by the project to the average investment in the project.

ROI = Average Income / Average Investment

Average Income = Average Net Profit after taxes from investment

Average Investment = (Beginning Investment + Ending Salvage Value)/ 2

Decision Rule: ROI > Cut off ROI

Limitations:

(a) Accounting Income can be fudged using accounting techniques

(b) Book Value is often an unreliable measure of the true investment in the project.

2. You are the divisional manager of a company that evaluates divisional managers on the basis of their return on investment (defined to be net income divided by the book value of the assets in the division). Last year you made $ 3 million and had a return on investment of 30%. You know that your machines are old and inefficient. If replaced, your profits will jump to $ 5 million. It will cost you $ 10 million to do the upgrade. Would you?
* Yes, I would
* No, I would not.

II. Cash flow Measures

Payback: This is the measure of the number of years before the initial investment in the project is made back (in cash flows).

Decision Rule: Payback < Cutoff Payback period

Limitations:

(a) It does not consider cash flows after the payback period

(b) It is difficult to compare payback periods.



Using the payback in decision making

* Payback is more a measure of risk than return. A project with a lower payback is generally considered to be less risky than one with a higher payback.

* Payback is much more important for firms with cash flow problems. For instance, highly leveraged firms are more likely to use payback than firms with significant cash flows.

* Payback is much more important in businesses where there is significant uncertainty about the life of the project (because of technological or other changes).

3. You are comparing two projects on the basis of payback - one has a payback of 3 years and the other has a payback of 5 years. Which of the following statements do you most agree with ñ
* The project with the lower payback is the better project
* The project with the lower payback is the less risky project
* it is difficult to draw any conclusion based purely on the payback
III. Discounted Cash flow Measures

Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment)

NPV = Sum of CFt /(1+r)t - Initial Investment

Decision Rule: Accept if NPV > 0

Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the net present value equal to zero.

Decision Rule: Accept if IRR > Discount rate

4. One of the arguments for using IRR is that you do not need a discount rate (whereas you do for the NPV). Do you agree with this statement?
* Yes
* No

Discounted Payback: This is a measure of the number of years before the initial investment is made back (in discounted cashflows)

Decision Rule: Accept if discounted payback < Cutoff payback

Assumptions Of NPV Rule

a. The Reinvestment rate assumption: The NPV rule assumes that shareholders can invest their money at the opportunity cost of capital. Since this is market determined this is the correct assumption.

b. The Value Additivity Principle:

NPV(A+B+C)= NPVA + NPVB + NPVC

The implication is that the value of a firm is the sum of the net present values of all its projects. No other decision rule has this property.

5. A firm with a value of $ 100 million takes a project with a net present value of -$5 million. What should the value of this firm be after the project is taken?

c. Term structure of interest rates

If interest rates are expected to change and such expectations can be quantified the NPV rule is flexible enough to allow it

NPV = CF1/ (1+r1) + CF2/(1+r1)(1+r2)

where rn = One-year interest rate in year n

NPV Profiles

A NPV profile estimates the NPV at various discount rates. It is useful because it illustrates the sensitivity of the net present value to the discount rate. Consider the following example:

Time Cash flow

0 -12337

1 +10000

2 + 5000

The NPV profile looks as follows:



MULTIPLE IRRs

Consider the following investments:

Investment	CF - Year 0	CF - Year 1	Cf - Year 2	IRR
R	-100	30	130	30%
S	0	-280	350	25%
I	-100	310	220	10% OR 100%

* Why is there more than one IRR for project I?

* Which of the IRRs would you choose to use in your decision?

IRR vs. NPV: SCALE OF CASHFLOWS

	Project X	Project Y	Project Z
Initial Investment	-100,000	-1,000,000	-100
Cashflow in Year 1	+140,000	+1,250,000	+150
NPV (@15%	21,739	86,957	30
IRR	40%	25%	50%

* If these projects were mutually exclusive and not replicable, which one would you choose? Why?

IRR vs. NPV: TIMING OF CASHFLOWS

Year	Project A	Project B
0	-1,000,000	-1,000,000
1	800,000	100,000
2	300,000	400,000
3	200,000	500,000
4	100,000	800,000
NPV	81,154	116,781
IRR	22.99%	21.46%

One solution that has been suggested for the reinvestment rate assumption is to assume that intermediate cash flows get reinvested at the hurdle rate and to calculate the internal rate of return from the initial investment and the terminal value. This approach yields what is called the modified internal rate of return (MIRR).

Cost of project investment = $50000 Salvage value = $10000

Life expectancy for project = 5 years Tax rate = 40%

Investment tax credit = 10% Revenues/ year = $40000

Depreciation method = Straight line Expenses/year = $20000

Financing: The project will be financed with owner's equity. The discount rate is 10%.

Cost of project investment = $50000 Salvage value = $10000

Life expectancy for project = 5 years Income Tax rate = 40% *CG rate = 20%

Investment tax credit = 10% Revenues/ year = $40000 *Growth =10%

*Depreciation method =DDB Expenses/year = $20000 *Growth = 10%

* Working capital needs: $10000 initially and maintained at 25% of revenues over time.

* The project will use equipment already owned by the company. If the project is not taken this equipment would have been sold for $10000. It has a book value of $5000.

Financing: The project will be financed with owner's equity. The discount rate is 10%.

* The Effects Of Depreciation On NPV

Straight line Depreciation:

Year	Depreciation	Tax Savings	PV
1	8000	3200	2909
2	8000	3200	2645
3	8000	3200	2405
4	8000	3200	2186
5	8000	3200	1987

SUM OF PV OF TAX SAVINGS =12132

DDB Depreciation:

Year	Depreciation	Tax Savings	PV
1	20000	8000	7273
2	12000	4800	3967
3	7200	2880	2164
4	800	320	219
5	0	0	0

SUM OF PV TAX SAVINGS = 13623

7. You have invested $100 million in an item, which can be expensed or depreciated. Which of the following choices will have the most favorable impact on current net income?
* Depreciate the item using straight line depreciation.
* Depreciate the item using accelerated depreciation
* Expense the item.

8. Which of the choices above will have the most favorable impact on current cash flows?
* Depreciate the item using straight line depreciation.
* Depreciate the item using accelerated depreciation
* Expense the item.

Proposition 1: Generally speaking, the net present value of a project will increase if we shift from straight line depreciation to accelerated depreciation, and the more accelerated the depreciation, the greater the net present value.
Question: There are two exceptions to this proposition. What are they?

* The Effects Of Changes In Working Capital

WORKING CAPITAL = NON-CASH CURRENT ASSETS - CURRENT LIABILITIES

Why working capital affects cash flows

Funds invested in working capital cannot be used elsewhere. Any increase in working capital will reduce cash flows available for other uses, and any decrease in working capital will increase cash flows.

Questions On Working Capital

1. To start this project, do I need any initial working capital?

2. After the project is under way, are there any changes in working capital?

Increase in working capital -> Decrease in cashflow

Decrease in working capital -> Increase in cashflow

3. At the end of the project lifetime, how much can be salvaged from working capital?

9. You are looking at a project analysis, which yields a net present value of $ 18,829. The project analyst, however, failed to consider working capital requirements in calculating the net present value. (The working capital investment needed is $ 10,000 initially, and will increase by $ 4,641 over the next five years, but the entire amount of $14,641 will be salvaged at the end of the fifth year. The entire amount will be salvaged at the end of the project life, and the discount rate is 10%). What effect will considering working capital have on the net present value?
* It will increase the net present value.
* It will not affect the net present value.
* It will decrease the net present value.

Ignoring working capital will lead to --

a. over-estimation of NPV

b. failure to plan for cashflow needs

In this project, the effects of working capital are as follows -

Year	Revenues	Working Capital	Change in WC	Effect on Cash Flow
0	-	10000	10000	-10000
1	40000	10000	0	0
2	44000	11000	1000	-1000
3	48400	12100	1100	-1100
4	53240	13310	1210	-1210
5	58564	14641	1331	-1331
Total				-14641

Effect on NPV = -10,000 - 1,000/1.12 - 1,100/1.13 - 1,210/1.14 - 1,331/1.15 +

14,641/1.15 = - $4,215

* Estimating Opportunity Cost

What do you lose by taking this project?

The opportunity to sell the van for $10000

What do you save by taking this project?

(1) The capital gains you would have paid on the sale price:

(Sale price - Book value) * Capital gains rate = (10000 - 5000) * 0.20 = $1000

(2) You claim depreciation on the van for five more years

S(Depreciation per year * Tax rate * PV factor)

= 1000 * 0.40 * (1 -(1/(1.1)^5))/0.1 = 1516

10. Assume that, in the example of the van, instead of planning to sell the van, you intended to rent it out for $ 2,000 a year for the next 5 years, if you do not take the project. What is the opportunity cost of the van?
* $ 10,000
* $ 7,581
* $ 4,549
* $ 6,065
* $ 3,033




THE EFFECTS OF UTILIZING EXCESS CAPACITY: IS THERE AN OPPORTUNITY COST?

Framework for analysis:

1. If the new product is not taken, when will the firm run out of capacity?- Year n

2. If the new product is taken, when will the firm run out of capacity?- Year n - t

3. When the firm runs out of capacity, what will the firm do?

3.1. Cut back on production of less profitable product - Compare contribution margins:

Cost = PV of lost cashflows on lost sales.

3.2. Build new capacity: Cost = PV of building capacity in n-t - PV of Building capacity in n

Choose Less Expensive Alternative In Present Value Terms

This Is Your Opportunity Cost

An example:

Existing Capacity = 100,000 units

Current Usage = 50,000 (50% of Capacity); 50% Excess Capacity;

New Product will use 30% of Capacity; Sales growth at 5% a year; CM per unit = $5/unit

Should there be a cost attached with the usage of this capacity?

Book Value = $1,000,000 Cost of a building new capacity = $1,500,000

Current product sales are growing at 10% a year. CM per unit = $4/unit

Year	Old	New	Old + New	Lost ATCF	PV(ATCF)
1	50.00%	30.00%	80.00%	$0
2	55.00%	31.50%	86.50%	$0
3	60.50%	33.08%	93.58%	$0
4	66.55%	34.73%	101.28%	$5,115	$3,251
5	73.21%	36.47%	109.67%	$38,681	$21,948
6	80.53%	38.29%	118.81%	$75,256	$38,127
7	88.58%	40.20%	128.78%	$115,124	$52,076
8	97.44%	42.21%	139.65%	$158,595	$64,054
9	107.18%	44.32%	151.50%
10	117.90%	46.54%	164.44%
			PV(LOST SALES)=		$179,456
PV (Building Capacity In Year 3 Instead Of Year 8) =
	=	1,500,000/1.12^3 -1,500,000/1.12^8=			$461,846

The opportunity cost of using excess capacity is $179,456, the lower of the two costs.

12. The net present value for the project, assuming all equity financing, is $ 17,678. Assume that you borrow $30,000 at 8% and take the same project. (Everything else about the projects is unchanged.) What will the effect on NPV be?
* The NPV will go up.
* The NPV will remain unchanged.
* The NPV will go down.

*There is insufficient information to answer the question.

PROBLEM 3: DEBT FINANCING

Cost of project investment = $50000 Salvage value = $10000

Life expectancy for project = 5 years Income Tax rate = 40% CG rate = 20%

Investment tax credit = 10% Revenues/ year = $40000 Growth =10%

Depreciation method =DDB Expenses/year = $20000 Growth = 10% Working capital needs: $10000 initially and maintained at 25% of revenues over time.

The project will use equipment already owned by the company. If the project is not taken this equipment would have been sold for $10000. It has a book value of $5000.

Financing: Borrow $30000 at 8% using a term loan. Balance is owner's equity

Year	Cashflows without	Cashflows with
	Debt	Debt
0	-62484	-32484
1	20000	13446
2	17000	10282
3	16300	9406
4	15082	7997
5	16238	8497
NPV	17678	21622

Debt is cheaper than equity, but it increases the cost of equity.

What determines this risk adjustment?

- The risk adjustment will be determined in large part by the business risk that the firm has taken on.

- A more explicit analysis of this risk adjustment will follow in the risk/return section.

I. SUNK COSTS

What are sunk costs? : Funds that have been spent already can be considered to be sunk costs.

How should they be treated?: Sunk costs are irrelevant from the viewpoint of capital budgeting since taking the project has no effect on these costs (They have already been spent.)

What about test market expenses?

IB. Test Market Expenses

Are test market costs sunk?

At the time of the project, yes.

Before the project, no.

Can test market expenses be ignored?

At the time of the capital budgeting analysis, yes.

But who pays for the test market expenses?

Test market expenses have to covered with profits from successful products.

To be successful, NPV of successful projects > Test Market costs

What about R&D Costs?

II. ALLOCATED COSTS

The allocation of existing costs to new products should not affect cashflows.

However, any incremental effect of new products on allocated costs should affect cashflows.

Example:

Total Administrative Costs before new project= $600,000 After new project = $660,000

Number of Existing Divisions = 5 Administrative Costs/Division = $120,000

Number of Divisions with new project=6 Administrative Costs/Division= $110,000

III. COSTS IMPOSED ON OTHER PRODUCTS

Product Cannibalization

A new product's sales may come at the expense of other products in the company's own line.

Should you consider this lost sales as part of the cost of the new project?

• The Home Depot, which was one of the great success stories of the late 80s and early 90s, has a strategy of opening huge home improvement stores, often in excess of 100,000 square feet.
• The initial cost to build and furbish such a store is estimated to be $12.5 million, and it is expected to generate annual sales of about $25 million for the company. The Home Depot is expected to borrow $ 5 million of the initial investment.

I. Return on Equity

If $5 million of this initial investment comes from borrowing, the book value of equity and the anticipated net income on the store are estimated to be as follows ñ

Year	BV of Equity	Depreciation	Net Income	Return on Equity
0	$7,500,000
1	$6,000,000	$ 1,500,000	$ (250,000)	-3.70%
2	$4,800,000	$ 1,200,000	$ 112,500	2.08%
3	$3,840,000	$ 960,000	$ 418,125	9.68%
4	$3,072,000	$ 768,000	$ 679,031	19.65%
5	$2,457,600	$ 614,400	$ 904,983	32.73%
6	$1,966,080	$ 491,520	$ 1,103,832	49.91%
7	$1,572,864	$ 393,216	$ 1,281,904	72.45%
8	$1,258,291	$ 314,573	$ 1,444,303	102.03%
9	$1,006,633	$ 251,658	$ 1,595,161	140.86%
10	$805,306	$ 201,327	$ 1,737,834	191.82%
Average	$3,116,252		$ 902,767	61.75%

• The increase in the return on equity over time mirrors the increase in the return on capital over the same period, but is even more noticeable.
• The average return on equity of 61.75% on the project is compared to the cost of equity, which is 15% for The Home Depot, suggesting that this store is a very good investment for the company.

II. Estimating Cash Flows to Equity

The free cash flows to equity are estimated from the net income for the store. It is expected that 40% of net capital expenditures and working capital needs will be financed with debt.

Year	Net Income	Equity Capital Investment	Depreciation	Increase in Work. Cap.	ATCF to Equity
1	$ (250,000)		$ 1,500,000	$ 125,000	$ 1,125,000
2	$ 112,500		$ 1,200,000	$ 131,250	$ 1,181,250
3	$ 418,125		$ 960,000	$ 137,813	$ 1,240,313
4	$ 679,031		$ 768,000	$ 144,703	$ 1,302,328
5	$ 904,983	$ 720,000	$ 614,400	$ 151,938	$ 647,445
6	$ 1,103,832		$ 491,520	$ 159,535	$ 1,435,817
7	$ 1,281,904		$ 393,216	$ 167,512	$ 1,507,608
8	$ 1,444,303		$ 314,573	$ 175,888	$ 1,582,988
9	$ 1,595,161		$ 251,658	$ 184,682	$ 1,662,137
10	$ 1,737,834		$ 201,327	$ 193,916	$ 4,122,787

Again, the cash flows to equity in year 10 include the salvage value of working capital and the book value of equity in the investment, net of principal repayment.

III. Estimating Payback

Year	FCFE	Cumulative CF	Year	FCFE	Cumulative CF
0	($7,500,000)	($7,500,000)	6	$ 1,435,817	$ (567,848)
1	$ 1,125,000	$ (6,375,000)	7	$ 1,507,608	$ 939,760
2	$ 1,181,250	$ (5,193,750)	8	$ 1,582,988	$ 2,522,747
3	$ 1,240,313	$ (3,953,438)	9	$ 1,662,137	$ 4,184,885
4	$ 1,302,328	$ (2,651,109)	10	$ 4,122,787	$ 8,307,672
5	$ 647,445	$ (2,003,665)

IV. Estimating NPV of Project

• The net present value is computed from the equity investorsí standpoint, using the projected cash flows for the prospective store opening for The Home Depot.

Year	Net Income	Equity Investment	Depreciation	D WC	FCFE	PV of FCFE
0		7500000			-7500000	-7500000
1	-250000		1500000	125000	1125000	978261
2	112500		1200000	131250	1181250	893195
3	418125		960000	137813	1240313	815526
4	679031		768000	144703	1302328	744610
5	904983	720000	614400	151938	647445	321894
6	1103832		491520	159535	1435817	620743
7	1281904		393216	167512	1507608	566766
8	1444303		314573	175888	1582988	517482
9	1595161		251658	184682	1662137	472483
10	1737834		201327	193916	4122787	1019090
					NPV =	-549951

Based upon the cost of equity of 15%, and the projected cash flows to equity investors from this store, the net present value is negative, suggesting that this store is not a good investment for The Home Depot.

• At the time of this analysis in 1989, Boeing had already spent $ 2 billion in research and development costs on the new plane, and anticipated spending $4 billion more in new investments. All of these costs were to be capitalized.

I. Estimating Operating Income and Return on Capital

• Based upon the anticipated sales of the plane, Boeing projected operating income (EBIT) and depreciation over a 15-year life for the project:

Return on Capital_t = Operating Income*2 / (BV of Assets_t-1 + BV of Assets_t)

After-tax Return on Capital = Return on Capital (1 - tax rate)

• The average after-tax return on capital anticipated on the project was 26.86%, which was well above the cost of capital of 12%.

II. Calculating Net Present Value

The following table calculates the present value of the cash flows to Boeing, as a firm, from the Boeing 777 project, using the cost of capital of 12% as the discount rate on the cash flows. 15

Year	EBIT (1-t)	Cap. Exp	Depreciation	D WC	FCFF	PV of FCFF
0		4000			-4000	-4000
1	929		82	1722	-711	-635
2	1666		72	-17	1755	1399
3	1458		67	-343	1868	1330
4	1615		62	51	1626	1033
5	1620		61	-91	1772	1005
6	1507		61	102	1466	742
7	1647		61	42	1666	754
8	1922	489	61	247	1247	504
9	1658		102	-212	1972	711
10	922		98	431	588	189
11	1718		90	376	1432	412
12	1899		78	137	1840	472
13	1640	500	75	389	826	189
14	1172		73	604	641	131
15	1895		52	119	5385	984
NPV						5220