4. Capital Budgeting and Project Investment Decision-Making

1. 4. Capital Budgeting and Project Investment Decision-Making 4.1 Net Present Value 4.2 Other Investment Criteria 4.3 Mutually Exclusive Projects 4.4 Capital Rationing 4.5 Discounted Cash Flows, Not Profits 4.6 Incremental Cash Flows 4.7 Treatment of Inflation

2. 4. Project Investment Decision-Making 4.8 Separate Investment & Financing Decisions 4.9 How Firms Organize the Investment Process 4.10 Some “What If” Questions 4.10.1 Sensitivity Analysis 4.10.2 Scenario Analysis 4.11 Real Options and the Value of Flexibility

3. Net Present Value Net Present Value - Present value of cash flows minus initial investments. Opportunity Cost of Capital - Expected rate of return given up by investing in a project

4. A: Profit = - $50 + $60 = $10 $10 Added Value $50 Initial Investment Net Present Value Example Q: Suppose we can invest $50 today & receive $60 later today. What is our increase in value?

5. $4.55 Added Value $50 Initial Investment Net Present Value Example Suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return? This is the definition of NPV

6. Net Present Value NPV = PV - required investment

7. Net Present Value Terminology C = Cash Flow t = time period of the investment r = “opportunity cost of capital” • The Cash Flow could be positive or negative at any time period.

8. Net Present Value Net Present Value Rule Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.

9. Net Present Value Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building?

10. 0 1 2 3 Present Value 14,953 13,975 380,395 $409,323 Net Present Value $466,000 Example – continued(7% WACC) $450,000 $16,000 $16,000 $16,000

11. Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?

12. Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?

13. Payback Method Payback Period - Time until cash flows recover the initial investment of the project. • The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement; however time to “+” cash flow is a critically useful measure.

14. + 7,249 • 264 • 347 Payback Method Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows ProjectC0C1C2C3Payback NPV@10% A -2000 +1000 +1000 +10000 B -2000 +1000 +1000 0 C -2000 0 +2000 0 2 2 2

15. Other Investment Criteria Internal Rate of Return (IRR) - Discount rate at which NPV = 0. Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

16. Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?

17. Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? IRR = 12.96%

18. Internal Rate of Return

19. Internal Rate of Return IRR=12.96%

20. Internal Rate of Return Example You have two proposals to choice between. The initial proposal (H) has a cash flow that is different than the revised proposal (I). Using IRR, which do you prefer?

21. Internal Rate of Return Example You have two proposals to choice between. The initial proposal (H) has a cash flow that is different than the revised proposal (I). Using IRR, which do you prefer?

22. Internal Rate of Return Pitfall 1 - Mutually Exclusive Projects • IRR sometimes ignores the magnitude of the project. Pitfall 2 - Lending or Borrowing • With some cash flows the NPV of the project increases as the discount rate increases. • This is contrary to the normal relationship between NPV and discount rates. Pitfall 3 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates (if there are future negative cash flows)

23. Project Interactions When you need to choose between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project, and, from those options that have a positive NPV, choose the one whose NPV is highest.

24. Mutually Exclusive Projects Example Select one of the two following projects, based on highest NPV. assume 7% discount rate

25. Investment Timing Sometimes you have the ability: - to defer an investment - select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow.

26. Capital Rationing Capital Rationing - Limit set on the amount of funds available for investment. Soft Rationing - Limits on available funds imposed by management. Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market.

27. Profitability Index

28. Cash Flow vs. Accounting Income • Discount actual cash flows • Using accounting income, rather than cash flow, could lead to erroneous decisions. Example A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income.

29. Cash Flow vs. Accounting Income

30. Cash Flow vs. Accounting Income

31. Incremental Cash Flow cash flow with project cash flow without project - = Incremental Cash Flows • Discount incremental cash flows • Include All Indirect Effects • Forget Sunk Costs • Include Opportunity Costs • Recognize the Investment in Working Capital • Beware of Allocated Overhead Costs

32. Incremental Cash Flows IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? • If yes, do not include it in your analysis. • If no, include it.

33. Inflation INFLATION RULE • Be consistent in how you handle inflation!! • Use nominal interest rates to discount nominal cash flows. • Use real interest rates to discount real cash flows. • You will get the same results, whether you use nominal or real figures

34. Separation of Investment & Financing Decisions • When valuing a project, ignore how the project is financed. • Following the logic from incremental analysis ask yourself the following question: Is the project existence dependent on the financing? If no, you must separate financing and investment decisions.

35. Capital Budgeting Process Capital Budget - The list of planned investment projects. The Decision Process 1 - Develop and rank all investment projects 2 - Authorize projects based on: • Legal need • Core business • Production efficiency • Capacity requirements • NPV

36. Capital Budgeting Process • Capital Budgeting Problems • Consistent forecasts • Conflict of interest • Corporate politics • Forecast bias • Selection criteria (NPV and others)

37. How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

38. Sensitivity Analysis Example Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.

39. Sensitivity Analysis Example – continued (,000s) NPV= $478

40. Sensitivity Analysis Example - continued Possible Outcomes

41. Sensitivity Analysis Example - continued NPV Calculations for Pessimistic Investment Scenario NPV= ($121)

42. Sensitivity Analysis Example - continued NPV Possibilities

43. Scenario Analysis Combine alternative sensitivities on the key risk variables in your cash flow statement and their probabilities to develop a set of possible outcomes and probabilities.

44. Real Options • Invest • Don’t Invest • Delay the Investment • Flexible Investment