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Principles of Capital Budgeting

Principles of Capital Budgeting. Project classifications Role of financial analysis Cash flow estimation Breakeven and profitability measures The post audit. What is capital budgeting?. Analysis of potential additions to a business’ fixed assets. Such decisions:

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Principles of Capital Budgeting

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  1. Principles of Capital Budgeting • Project classifications • Role of financial analysis • Cash flow estimation • Breakeven and profitability measures • The post audit

  2. What is capital budgeting? • Analysis of potential additions to a business’ fixed assets. • Such decisions: • Typically are long-term in nature. • Often involve large expenditures. • Usually define strategic direction. • Thus, such decisions are very important to a business’ future.

  3. Project Classifications • For analysis purposes, projects are classified according to purpose and size. For example, • Mandatory replacement • Expansion of existing services • Expansion into new services

  4. Role of Financial Analysis • For investor-owned firms, financial analysis identifies those projects that are expected to contribute to shareholder wealth. • For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’ financial condition.

  5. Overview of Capital Budgeting Financial Analysis 1. Estimate the capital outlay. 2. Forecast the cash inflows: • Operating flows • Terminal flows 3. Assess the project’s riskiness. 4. Estimate the cost of capital. 5. Measure the financial impact.

  6. Key Concepts in Cash Flow Estimation • Incremental cash flows: Inc. CF = CF(w/ project) - CF(w/o project). • Cash flow versus accounting income • Cash flow timing • Project life

  7. Key Concepts (Cont.) • Sunk costs • Opportunity costs: • For capital • For other resources • Effects on other business lines • Shipping and related costs

  8. Key Concepts (Cont.) • Working capital effects: • Current assets • Current liabilities • Inflation effects • Strategic value

  9. Cash Flow Estimation Example • Assume Northwest Healthcare, a not-for-profit hospital, is evaluating a new piece of diagnostic equipment • Cost: • $200,000 purchase price • $40,000 shipping and installation • Expected life = 4 years. • Salvage value = $140,000.

  10. Cash Flow Estimation Example (Cont.) • Utilization = 5,000 scans/year. • Charge = $80 per scan. • Variable cost = $40 per scan. • Fixed costs = $100,000. • Corporate cost of capital = 10%.

  11. Time Line Setup 0 1 2 3 4 Initial Costs OCF1 OCF2 OCF3 OCF4 + (CF0) Terminal CF NCF0 NCF1 NCF2 NCF3 NCF4

  12. Investment at t = 0 (000s) Equipment $200 Installation & Shipping 40 Net investment outlay $240

  13. Operating cash flows (000s) 1 2 3 4 Revenues $400 $400 $400 $400 Total VC 200 200 200 200 Fixed costs 100 100 100 100 Depreciation 25 25 25 25 BT op. inc. $ 75 $ 75 $ 75 $ 75 Taxes -- -- -- -- $ 75 $ 75 $ 75 $ 75 AT op. inc. Depreciation 25 25 25 25 Net op. CF $100 $100 $100 $100

  14. Should the CFs on the previous slide have included interest expense or dividends? No. Financial costs are accounted for by discounting the net cash flows at the 10% corporate cost of capital. Thus, deducting interest or dividends from the estimated cash flows would be “double counting” financing (capital) costs.

  15. Terminal cash flows at t = 4 (000s) Salvage value $140 Tax on SV 0 Net terminal CF $140 • How are salvage value taxes determined for investor-owned firms?

  16. Suppose $5,000 had been spent last year to improve the space for the new diagnostic equipment. Should this cost be included in the analysis? No. This is a sunk cost. The money has already been spent, so project acceptance would have no effect on that flow. Cash flows in the analysis must be incremental to the project.

  17. Suppose the space could be leased out for $12,000 a year. Would this affect the project’s cash flows? Yes. Accepting the project means that Northwest Healthcare is foregoing a $12,000 cash inflow. This is an opportunity cost that should be charged to the project.

  18. If the new equipment would decrease patient utilization of existing services, would this affect the analysis? • Yes. The effect on other CFs within the business is an “externality.” • The net CF loss each year on other services would be a cost to this project. • Externalities can be either positive or negative.

  19. Net cash flows (000s) 2 3 4 0 1 -240 100 100 100 100 140 240

  20. If this were a replacement rather than a new (expansion) project, would the analysis change? • The relevant operating CFs would be the difference between the CFs on the new and old equipment. • Also, selling the old equipment would produce an immediate cash inflow, but the salvage value at the end of its original life is foregone.

  21. Breakeven Analysis • There are many different approaches to breakeven in project analysis: • Time breakeven • Input variable breakeven • Utilization • Charge • We will focus on payback (or payback period), a measure of time breakeven.

  22. What is the project’s payback? 2 4 0 1 3 -240 100 100 100 240 Cumulative CFs: -240 -140 -40 60 300 Payback = 2 + 40 / 100 = 2.4 years.

  23. Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores time value. 2. Ignores all CFs occurring after the payback period.

  24. Profitability Analysis • Profitability analysis focuses on a project’s return. • As with any investment, returns can be measured either in dollar terms or in rate of return (percentage) terms. • Net present value (NPV) measures a project’s dollar return. • Internal rate of return (IRR) measures a project’s rate of return.

  25. Net Present Value (NPV) • NPV is merely the sum of the present values of the project’s net cash flows. • The discount rate used is called the project cost of capital. If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%.

  26. What is the project’s NPV? 4 0 1 2 3 10% -240.00 100 100 100 240 90.91 82.64 75.13 163.93 172.61 = NPV

  27. Financial Calculator Solution Enter in CFj registers: -240 100 100 100 240 CF0 Then: CF1 I = 10 CF2 And solve for: CF3 NPV = 172.61 CF4

  28. Interpretation of the NPV • NPV is the dollar contribution of the project to the equity value of the business. • A positive NPV signifies that the project will enhance the financial condition of the business. • The greater the NPV, the more attractive the project financially.

  29. Internal Rate of Return (IRR) • IRR measures a project’s percentage (rate of) return. • It is the discount rate that forces the PV of the inflows to equal the cost of the project. In other words, it is the discount rate that forces the project’s NPV to equal $0. • IRR is the project’s expected rate of return.

  30. What is the project’s IRR? 4 0 1 2 3 IRR = ? -240.00 100 100 100 240 ? ? ? ? 0.00 = NPV

  31. What is the project’s IRR? (Cont.) 1 2 3 4 0 IRR = 35.4% -240.00 100 100 100 240 73.84 54.53 40.27 71.36 0.00 = NPV Therefore, IRR = 35.4%.

  32. Calculator Solution Enter in CFj registers: -240 100 100 100 240 And solve for: CF0 IRR = 35.4% CF1 CF2 CF3 CF4

  33. Interpretation of the IRR • If a project’s IRR is greater than its cost of capital, then there is an “excess” return that contributes to the equity value of the business. • In our example, IRR = 35.4% and the project cost of capital is 10%, so the project is expected to enhance Northwest’s financial condition.

  34. Comparison of NPV and IRR NPV ($) k > IRR and NPV < 0. Value is decreased. IRR > k and NPV > 0. Value is increased. Cost of Capital (%) IRR Here, k = project cost of capital.

  35. Capital Budget Decision Making • Responsibility resides with: • Senior-level management/GB for expansion-type capital projects • Mid-level management for replacement-type capital projects • Decision criteria summary • Strategic importance of project • “Appropriate” project returns anticipated • “Manageable” level of project risk

  36. Capital Budget Decision Making • Evaluating projects with unequal lives • Mutually exclusive projects having different useful life periods • Comparing apples to oranges • Evaluation methods • Replacement chain analysis method • “Force” projects to have equal lives by allowing unlimited replication • Assumes that cash flow projections and cost of capital won’t change upon replication • Difficulty in finding “lowest common denominator” for similar project lives (5 vs. 6)

  37. Capital Budget Decision Making • Equivalent Annual Annuity Method • Given projected project NPV, estimate “implied” annuity (PMT) associated with stream of cash flows • Enter NPV as PV in calculator, cost of capital as ‘I’, and # of years as N, find PMT • Project with highest estimated EAA is preferred • Like RCA method, assumes that projects can be costlessly replicated indefinitely.

  38. Capital Budgeting in NFP Businesses • Measures thus far have focused on the financial impact of a project. • Presumably, NFPs have important goals besides financial ones. Other considerations can be incorporated into the analysis by using: • The net present social value (NPSV) model.

  39. Capital Budgeting in NFP Businesses • TNPV = NPV (fin.) + NPSV (social) • Preferred projects have high TNPV • No investments in projects where NPSV < 0 (regardless of NPV) • Average TNPV for all projects = 0 • Estimation of NPSV -- willingness to pay methodology (conceptual) • The “social” cost of capital

  40. Post Audit • The post audit is a formal process for monitoring a project’s performance over time. • It has several purposes: • Improve forecasts • Develop historical risk data • Improve operations • Reduce losses

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