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Capital Budgeting: To Invest or Not To Invest

Capital Budgeting: To Invest or Not To Invest. Capital Budgeting Decision usually involves long-term and high initial cost projects. Invest if a project’s “value” >= “cost”. Estimating initial costs Estimating “value” Estimate future cash flows: timing (when?) size (how much?)

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Capital Budgeting: To Invest or Not To Invest

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  1. Capital Budgeting: To Invest or Not To Invest • Capital Budgeting Decision • usually involves long-term and high initial cost projects. • Invest if a project’s “value” >= “cost”. • Estimating initial costs • Estimating “value” • Estimate future cash flows: • timing (when?) • size (how much?) • risk (standard deviation, range, Min-Max?) • Estimate discount rate • Opportunity cost of capital • Risk of future cash flows

  2. Mutually Exclusive vs. Independent Project • Mutual Exclusive Projects • only ONE of several potential projects can be chosen • e.g. acquiring an accounting system. • RANK all alternatives and select the best one. • Independent Projects • accepting or rejecting one project does not affect the decision of the other projects. • Must exceed a MINIMUM acceptance criteria

  3. Net Present Value (NPV) • Net Present Value (NPV) • = Total PV of future CF’s – Initial • Reminder: PV = CFt / (1 + r)t • Reinvestment assumption • the NPV rule assumes that all cash flows can be reinvested at the discount rate. • Minimum Acceptance Criteria: • Accept if NPV >= 0 • Ranking Criteria: • Choose the highest NPV

  4. Good Attributes of NPV Rule • Uses cash flows, not accounting earnings • Uses ALL cash flows of the project • Discounts ALL cash flows properly • Incorporates TVM • Reinvestment assumption makes economic sense

  5. The Profitability Index (PI) • PI = Total Present Value of future CF’s / Initial Investment • Reinvestment assumption • the PI rule assumes that all cash flows can be reinvested at the discount rate. • Minimum Acceptance Criteria: • Accept if PI >= 1 • Ranking Criteria: • Select alternative with highest PI

  6. PI (continued) • Disadvantages: • 1. May lead to incorrect decisions when comparing mutually exclusive investments • Advantages: • 1. May be useful when available investment funds are limited • 2. Easy to understand and communicate • 3. Correct decision when evaluating independent projects

  7. Internal Rate of Return (IRR) • IRR • Defined as the discount that sets the NPV to zero • Reinvestment assumption: • the IRR calculation assumes that all future cash flows are reinvested at the IRR • Minimum Acceptance Criteria: • Accept if the IRR >= required return • Ranking Criteria: • Select alternative with the highest IRR

  8. IRR (continued) • Disadvantages: • IRR may not exist or multiple IRR’s • May lead to incorrect decisions when comparing mutually exclusive investments • Reinvestment assumption may be unrealistic if project IRR is exceptionally high • Advantages: • Easy to understand and communicate • Correct decision when evaluating independent projects with conventional cash flows

  9. NPV Profile • A graph showing the relationship between discount rate and NPV • Usually a downward sloping curve • Negative relationship between discount rate and NPV • A tool for computing IRR before computers • Useful for detecting multiple IRRs when project has abnormal cash flows • Crossover Rate • Discount rate at which 2 projects have the same NPV

  10. Payback Period Rule • How long does it take for the project to “pay back” its initial investment? • Payback Period = # of years to recover initial costs • Minimum Acceptance Criteria: • Set by management. • Ranking Criteria: • Select alternative with the shortest payback period

  11. Payback Rule (continued) • Disadvantages: • 1. Ignores the time value of money • 2. Ignores CF after payback period • 3. Biased against long-term projects • 4. Payback period may not exist or multiple payback periods • 5. Requires an arbitrary acceptance criteria • 6. A project accepted based on the payback criteria may not have a positive NPV • Advantages: • 1. Easy to understand • 2. Biased toward liquidity

  12. Discount Payback Rule • Similar to Payback except use discounted cash flow instead of cash flow to compute payback period. • Still has all the disadvantages of the payback rule except taking into acount TVM

  13. Investment Rules: An Example Capital Budgeting Example.xls

  14. Cash Flows Estimation • Cash, CASH, CASH, CASH • Incremental • Sunk Cost • Opportunity Costs • Side Effects • Tax • After-tax (AT) value = Before-tax (BT) value * (1- Tax rate) • Inflation

  15. A Simplified (Incremental) Cash Flow Statement Revenue = Unit price x units sold - Variable Costs = Unit cost x units sold Gross Profit - Cash Fixed Costs - Depreciation EBIT (Earnings Before Interest and Tax, Operating Income/Profit) - Interest EBT (Earnings Before Tax, Taxable Income) - Tax Net Income/Profit (Profit After Tax) • Two common ways to computing Operating Cash Flow (OCF) • OCF = EBIT + Depreciation – Taxes • OCF = Net Income + Depreciation + AT interest

  16. Cash Flows for Projects (Free Cash Flows) • Net after-tax cash flow to the firm (Free Cash Flows) = Cash Flow from Operations - Addition to Fixed Assets - Addition to Net Working Capital • Net Working Capital (NWC) = Current assets – current liabilities • Additions to NWC = Ending NWC – Beginning NWC • Additions to fixed assets = Ending Net Fixed Assets (NFA) – Beginning NFA + depreciation • Or simply = the aggregate net assets purchased

  17. Depreciation • Depreciation is a non-cash expense • Affects taxes, which is a cash expense • Depreciation tax shield = Depreciation expense x tax rate • Depreciation Methods • IRS regulations • Accelerated method versus straight line • Depreciable basis = Purchase cost + shipping and installation • Depreciation Schedule • Book value = Depreciable Basis – Accumulated depreciation • Sale of Depreciated Assets • Capital Gain/loss = Resale value – Book value • Taxes on capital gain/loss = capital gain/loss x tax rate

  18. Another Way to Compute Cash Flows • After-tax cash revenue = Before-tax cash revenue x (1 - Tax Rate) • After-tax cash costs = Before-tax cash costs x (1 - Tax Rate) • Tax Shield from Depreciation = Depr. Expense x Tax Rate • OCF = AT revenue - AT costs + Depr tax shield • Addition to Fixed Assets • Addition to Net Working Capital • Net AT CF = AT revenue - AT costs + Depr tax shield - addition to assets - addition to NWC

  19. Summary on Estimating Cash Flows • Income statement approach • Use income statement to compute tax • OCF = Cash Revenue – Cash Expenses – taxes • Tax shield approach • OCF = (Cash Revenue – Cash Expenses) x (1- tax rate) + tax rate x Depreciation expense • Net after-tax cash flows to firm = OCF – additions to fixed assets – additions to NWC

  20. Two Ways to Compute NPV • Discount Net Total After-tax Increment Cash Flows • Discount all CFs at one rate • Discount Each Source of Cash Flows Individually • Allow each source of CF to be discounted at different rate • 1. Revenue and cost: nominal risky rate • 2. Depreciation tax shield: nominal risk-free rate

  21. Investments of Unequal Lives • Assumption: Both projects can and will be repeated • Repeat both projects until they begin and end at the same time • Compute NPV’s for the “repeated projects”

  22. Replacement Projects • Compute NPV of New Machine • Compute Equivalent Annual Cost (EAC) • NPV - as PV • Life of New Machine - as NPER • Discount rate used in computing NPV - as RATE • Equivalent Annual Cost (EAC) - compute PMT • Decision: Replace if EAC <= Cost of keeping the machine one more year

  23. The Bottom Line • NPV, IRR and PI will generally give us the same decision • Exceptions • Non-conventional cash flows • cash flow signs change more than once • Mutually exclusive projects • Initial investments are substantially different • Timing of cash flows is substantially different • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV

  24. Capital Budgeting In Practice • We should consider several investment criteria when making decisions • NPV and IRR are the most commonly used primary investment criteria • Payback is a commonly used secondary investment criteria

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