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Chapter 17
Capital Budgeting Analysis
© 2011 John Wiley and Sons
Chapter Outcomes



Explain how the capital budgeting
process should be related to a firm’s
mission and strategies.
Identify and describe the five steps in
the capital budgeting process.
Identify and describe the methods or
techniques used to make proper
capital budgeting decisions.
2
Chapter Outcomes, continued


Explain how relevant cash flows are
determined for capital budgeting
decision purposes.
Discuss how a project’s risk can be
incorporated into capital budgeting
analysis.
3
Capital Budgeting Projects


Seek investment opportunities to enhance
a firm’s competitive advantage and
increase shareholder wealth
– Typically long-term projects
– Should be evaluated by time value of
money techniques
– Large investment
– Relate to firm’s mission
Mutually exclusive versus independent
4
Identifying Potential Capital Budget
Projects
Time value concepts tell us:
Value = present value of expected cash
flows
 Separating out the initial up-front
cost, we have:
Net Present Value = Present value of
expected cash flows – cost of project

5
Identifying Potential Capital Budget
Projects



Net Present Value = Present value of
expected cash flows – cost of project
If NPV >0 the project adds value to
the firm.
Where do firms find attractive capital
budgeting projects with potentially
positive NPVs?
6
Identifying Potential Capital Budget
Projects



Planning tools:
MOGS: Mission, Objectives, Goals,
Strategies
SWOT: (Internal to firm):Strengths,
Weaknesses
(External to firm): Opportunites,
Threats
7
Capital Budgeting Process





Identification
Development
Selection
Implementation
Follow-up
8
Data Needs

Economic and Political Data

Financial Data

Non-Financial Data
9
Oil/Gas Company Projects
Ranking of items from most to least
important on capital spending:
1.
Natural gas price forecast
2.
Crude oil price forecast
3.
Natural gas demand forecast
4.
Crude oil demand forecast
5.
Availability and cost of capital
6.
Regulatory requirements on projects
7.
Tax considerations
10
Forecasts


Note the multiple uses of the word
“forecast” in the previous list
Managers must make educated
guesses about the future to estimate
future cash flows
11
Capital Budgeting Techniques

Net Present Value

NPV = Present value of all cash flows
minus cost of project
Inputs: cash in/outflows, required
rate of return or “cost of capital”

12
Cash Flow Data
YEAR
0 (today)
PROJECT A
-20,000
PROJECT B
-25,000
1
5,800
4,000
2
5,800
4,000
3
5,800
8,000
4
5,800
10,000
5
5,800
10,000
13
NPV of Project A
CASH
10%
PRESENT
YR FLOW x PVIF = VALUE
0 –$20,000 1.000 –$20,000
1
5,800 0.909
5,272
2
5,800 0.826
4,791
3
5,800 0.751
4,356
4
5,800 0.683
3,961
5
5,800 0.621
3,602
Net Present Value =$ 1,982
14
15
NPV of Project B
CASH
10%
PRESENT
YR FLOW x PVIF = VALUE
0 -$25,000 1.000
-$25,000
1
4,000 0.909
3,636
2
4,000 0.826
3,304
3
8,000 0.751
6,008
4
10,000 0.683
6,830
5
10,000 0.621
6,210
Net Present Value =
$ 988
16
What Does the NPV Represent?



NPV represents the dollar gain in
shareholder wealth from undertaking
the project
If NPV > 0, do the project as
shareholder wealth rises
If NPV <0, do not undertake; it
reduces shareholder wealth
17
Internal Rate of Return
It is the discount rate that causes NPV
to equal zero
N
NPV =
 [CFt / (1 + IRR)t ] – Inv = 0
t= 1
18
NPV Profile
Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile
10000.00
8000.00
NPV ($)
6000.00
4000.00
2000.00
0.00
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.10
0.11
0.12
0.13
0.14
0.15
0.16
0.17
-2000.00
Discount Rate (in decim al)
19
Solution Methods


Compute the IRR by:
– Trial and error
– Financial calculator
– Spreadsheet software
Accept the project if IRR > minimum
required return on the project
20
21
What Does the IRR Measure?
IRR measures the return earned
on funds that remain internally
invested in the project
22
(1)
(2)
Year Beginning
Investment
Value
1
2
3
$5,000.00
3,489.43
1,827.80
*Value
(3)
Cash
Inflow
(savings)
Funds
(4)
10% Return
on the
Invested
Funds
(2) x 0.10
$2,010.57 $500.00
2,010.57 348.94
2,010.57 182.78
(5)
Reduction
in the
Invested
(3) - (4)
(6)
Ending
Value of
Invested
Funds
(2) - (5)
$1,510.57
1,661.63
1,827.79
$3,489.43
1,827.80
0.01*
is not 0.00 due to rounding.
23
NPV vs. IRR





They will always agree on whether to
accept or reject a project
So if projects are independent: either
method is acceptable
Problem: they may rank projects
differently
What to do if projects are mutually
exclusive and the rankings conflict?
Answer: use NPV as it measures the
change in shareholder wealth occurring
because of the project.
24
NPV vs. IRR



Another issue with IRR: a project
may have more than one IRR!
Can occur if project has alternative
positive and negative cash flows.
Most likely to occur if project
requires substantial renovations or
maintenance during its life or if endof-life shut-down costs are high.
25
Modified Internal Rate of Return




MIRR developed to solve some of the
issues associated with IRR.
MIRR will agree with NPV on the
accept/reject decision
MIRR gives a single answer—there is only
one MIRR
MIRR agrees with NPV rankings when the
initial investments are of comparable size.
26
Modified Internal Rate of Return:
Three step process
1.
2.
3.
Find the present value of all cash
outflows
Find the future value of all cash inflows
at the end of the project’s life at year n.
This lump sum is called the terminal
value.
MIRR is the discount rate which equates
the present value of the outflows and the
future value of the inflows:
FV at year n = PV (1 + MIRR)n
27
MIRR for Project A
Present value of outflows = 20,000 (no
additional calculation needed)
2.
Find FV as of year 5 for cash inflows
from years 1-5:
5800 (1.10)4 = 8491.78
5800 (1.10)3 = 7719.80
5800 (1.10)2 = 7018.00
5800 (1.10)1 = 6380.00
5800 (1.10)0 = 5800.00
Terminal value (sum of FV) = 35,409.58
1.
28
MIRR for Project A





PV of outflows: 20,000
Terminal value (sum of FV of inflows)
= 35,409.58
Step 3: FV = PV(1 + MIRR)n
= $35,409.58= $20,000(1 + MIRR)5
Solving, we find the MIRR is 12.10
percent
Accept project as MIRR>10%
required return
29
Profitability Ratio (Benefit/Cost
Ratio)




Profitability Index = Present value of
cash flows/initial cost
Accept project if PI > 1.0
Reject project if PI < 1.0
Interpretation: Measures the present
value of dollars received per dollar
invested in the project
30
Project A and B
Project A’s profitability ratio:
PI = $21,982/$20,000 = 1.099
Project B’s profitability ratio:
PI = $25,988/$25,000 = 1.040
31
Relationships



NPV, IRR, PI will always agree on the
Accept/Reject decision
If one indicates we should accept the
project, they will all indicate “accept”
NPV > 0 always means that:
IRR>minimum required return and
that the:
PI > 1
32
Reject Decision, too


If one indicates we should reject the
project, they will all indicate “reject”
NPV < 0 always means that the
IRR < minimum required return and
that the
PI < 1
33
Conflicts Between NPV, IRR, MIRR,
Profitability Index


May occur as different rankings may
occur if projects are mutually
exclusive. Most likely when projects
have:
Different cash flow patterns
– Projects with larger and earlier cash
flows may have higher IRR rankings
than those with larger later cash flows
34
Conflicts Between NPV, IRR, MIRR,
Profitability Index

Different time horizons
– Project Long and Project Short require
$100 investment
– Short: returns $200 in 2 years IRR =
41.42% and NPV (at 10% required
return) = $65.29.
– Long: returns $2,000 in 20 years IRR
=16.16% NPV (at 10% required return) =
$197.29.
35
Conflicts Between NPV, IRR, MIRR,
Profitability Index

Different Sizes
– Projects with smaller initial investments may
have higher IRR and higher PI and smaller NPV
than projects with larger initial investments.
Initial PV of Cash
Profitability
Project Outlay Cash Flows NPV
Index
Small $100
$150
$50
1.5
Large 1,000
1,100
$100
1.1
36
Conflicts Between NPV, IRR, MIRR,
Profitability Index





Four discounted cash flow methods:
NPV, IRR, MIRR, profitability index
Goal in capital budgeting is to select
projects that will help maximize
shareholder wealth.
NPV is the best as it measures the
absolute dollar change in shareholder
wealth.
The others are relative measures of
project attractiveness.
37
A popular, but flawed, measure...


Payback period = number of years
until the cash flows from a project
equal the project’s cost
Accept project is payback period is
less than a maximum desired time
period
38
Project A Payback Example
Investment: $20,000
Cash Cumulative
Dollars
YR Flow Cash flow
Needed
1
5,800
5,800
14,200
2
5,800 11,600
8,400
3
5,800 17,400
2,600
4
5,800
Fraction of year: 2,600/5,800 = 0.45
Payback = 3.45 years
39
Payback’s Drawbacks



Ignores time value of money
Any relationship between the
payback, the decision rule, and
shareholder wealth maximization is
purely coincidental!
It ignores the cash flows beyond the
payback period
40
What Managers Use



75% of CFOs used NPV, IRR or both
to evaluate projects
IRR is most popular
Over half still use payback as a
secondary or supplementary method
of analysis
41
Why Are IRR and Payback Used So
Much?

Safety margin
– IRR gives managers an intuitive feel for
a project’s “safety margin”—amount by
which cash flows can be incorrect and
the project can still increase
shareholder wealth.


Project Size
Managerial flexibility and options
42
Estimating Project Cash Flows
Important concepts:
 Stand-alone principle
 Incremental after-tax cash flows
from the base case
 Cannibalization or enhancement
effects
 Opportunity costs

43
Ignore….

Sunk costs

Financing costs
44
Project Cash Flows
Project sales (generally a cash inflow)
- Project costs (generally a cash outflow)
- Depreciation (a noncash expense)
EBIT = EBT
(earnings before interest and
taxes, which also equals earnings before taxes
as financing costs are ignored in cash flow
analysis)
- Taxes (a cash outflow)
Net income
45
Firm versus Project Statement of Cash Flows
The Firm's Cash Flow Statement
A Project's Cash Flow Statement
Cash Flow from Operations
Net Income
+Depreciation
+current asset/liability sources
-current asset/liability uses
Cash Flow from Investment Activities
-change in gross fixed assets
Cash Flow from Operations
Net Income
+Depreciation
+current asset/liability
sources
-current asset/liability
uses
Cash Flow from Investment
Activities
-Funds invested in the
project
-change in investments
Cash Flow from Financing Activities
Activities
-Dividends paid
+net new bond issues
+net new stock issues
Cash Flow from Financing
Not applicable
46
Project Cash Flows
Cash flows from operations: Net income +
depreciation – change in net working
capital
Cash flows from investment activities:
change in gross fixed assets
Cash flows from financing activities: ignore
Recall, as the cash account is always zero,
that the change in NWC does not include
the cash account
47
Operating Cash Flow





OCF = Net Income + Depreciation – ΔNWC
From the project’s income statement, this
is the same as:
(Sales-Costs-Depreciation) – Taxes +
Depreciation – ΔNWC
If the firm’s tax rate is t then
Taxes = t(pre-tax income) = t(Sales-CostsDepreciation) so operating cash flow is:
48
Operating Cash Flow




OCF =
Sales-Costs-Depreciation – t(Sales-CostsDepreciation) + Depreciation – ΔNWC
Simplifying, we have a general formula for
estimating operating cash flow:
OCF = (Sales-Costs-Depreciation)(1– t)
+ Depreciation – ΔNWC
49
Why do we subtract the
change in NWC (ΔNWC) ?




Recall NWC = Current Assets (excluding
the cash account) minus Current
Liabilities
If NWC rises: either CA has risen, CL has
fallen, or both
Example: Cash is used to pay AP; cash
flows out of the firm and NWC (CA-CL)
rises
A use of cash leads to an increase of
NWC; to measure operating cash flow, this
amount is subtracted.
50
Why do we subtract the
change in NWC (ΔNWC) ?



If NWC falls: either CA has fallen, CL has
risen, or both.
Example: Cash comes into the firm if a
customer pays their AR. AR falls, CA falls,
and NWC falls
A source of cash leads to a decrease of
NWC; when we subtract this negative
change in NWC it becomes a positive
addition to OCF.
51
The Depreciation Tax Shield
With Deprec Without Deprec
Expense
Expense
Sales
$1000
$1000
-Costs
-300
-300
-Deprec
-100
0
EBT
$600
$700
-Taxes (40%)
240
280
Net Income
$360
$420
OCF=Net Income + Depreciation
$460
$420
Difference is $40—which equals tax rate x
depreciation (04.0) ($100) = $40
52
Reality: Keeping Managers Honest


Pet projects can be accepted into the
capital budget by inflating cash flow
estimates so their NPV is positive
Possible solutions:
– Review spending in implementation stage;
additional requests for funds needed in case of
overruns
– Compare forecasted cash flows with actuals
– Record names of those issuing forecasts
53
Risk-related Considerations

Expected return/risk tradeoff

Higher (lower) than average risk
projects should have a higher (lower)
than average discount rate
54
Cost of Capital


Required return on average risk
project = firm’s cost of capital, or
cost of financing
For average risk projects, use this
number as the discount rate (NPV,
PI) or the minimum required rate of
return (IRR)
55
Risk-adjusted Discount Rate
Adjust the project’s discount rate up or
down from the firm’s cost of capital
for projects of above-average or
below-average risk
56
An Example
Below-average risk:
Discount rate = cost of capital –2%
Average risk:
Discount rate = cost of capital
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
57
Web Links
www.benjerry.com
www.wendys.com
www.wellsfargo.com
www.merck.com
www.dell.com
www.ebay.com
www.salvagesale.com
58
Learning Extension 17: Estimating Project
Cash Flows
59
Up-front or “time zero”
investment
Investment =
cost + transportation, delivery, and
installation charges
60
Project Stages and Cash Flow
Estimation

Initial Outlay
– Engineering estimates (designs,
modifications)
– Current market prices of new items
– Bid prices from possible supplies or
construction firms
– Will be reduced if new project is
replacing old equipment/building that
can be sold
61
Project Stages and Cash Flow
Estimation




Cash Flows During the Project’s Life
For each period of time during the
project’s life, use the general equation:
OCF = (Sales-Costs-Depreciation)(1– t)
+ Depreciation – ΔNWC
Estimating the inputs: marketing studies,
production cost estimates, suppliers
62
Project Stages and Cash Flow
Estimation

Salvage Value and NWC Recovery
– After-tax salvage value = Asset selling
price – t (selling price – book value)
– Project’s NWC may be assumed to be
liquidated (converted to cash) and
returned to the firm as a cash flow
63
Project Stages and Cash Flow
Estimation




Salvage value example. Asset purchased
for $100; depreciation of $10/year. Sold in
year 7. Book value will be $30. Tax rate is
25%.
After-tax salvage value if selling price is
$50: $50 – .25 ($50-30) = $45
After-tax salvage value if selling price is
$30: $30 – .25 ($30-30) = $30
After-tax salvage value if selling price is
$10: $10 – .25 ($10-30) = $15
64
Project Stages and Cash Flow
Estimation
If project is expected to continue
indefinitely:
 Estimate operating cash flows for several
years and then estimate its “going
concern value” using the constant
dividend (cash flow) growth model:
Dividendtime t+1
Valuetime t = ----------------------r-g

65
Example: Revenue-Expanding Project

Initial outlay:
Depreciable Outlays
Expensed Cash Outlays, after tax
t=0
-$4.5
-0.4
-------$4.9
66
Annual Project Income Statement
years 1-5
Sales
-Costs
-Depreciation
EBT
-Taxes (40%)
Net income
$3.000
-0.635
-0.900
$1.465
-0.586
$0.879
67
OCF estimates
tax rate = 40%
Saless
-Cost
-Depreciation
SUM
x (1-t)
+Depreciation
-change NWC
Operating CF
Year 1
$3.000
-$0.635
-$0.900
$1.465
$0.879
$0.900
-$0.100
$1.679
Year 2-4 Year 5
$3.000
$3.000
-$0.635 -$0.635
-$0.900 -$0.900
$1.465
$1.465
$0.879
$0.879
$0.900
$0.900
$0.000
$0.100
$1.779
$1.879
68
Salvage Value





Market value in year 5 of project assets:
$1 million
They will be fully depreciated at that time.
After-tax salvage value = Asset selling
price – t (selling price – book value)
= $1 million – (0.40)($1 million-0)
= $0.600 million
69
Cash Flow Summary
Initial Operating Salvage
Year Outlay Cash Flows Value
Total
Incremental
Cash Flows
0 $-4.9 $ 0.000 $ 0.0
1 0.0
1.679
0.0
2 0.0
1.779
0.0
3 0.0
1.779
0.0
4 0.0
1.779
0.0
5 0.0
1.879
0.6
At 10%, NPV = $2.20 million
$-4.90
1.679
1.779
1.779
1.779
2.479
70
Other Examples



Cost-saving project
Setting a minimum bid price on a
project so NPV=0
Tables, data in textbook
71