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Capital Budgeting

Capital Budgeting. Real Asset Valuation and Profitability NPV IRR MIRR Payback Cross-over rates Capital Budgeting process Cash flows that matter WACC Sensitivity analysis Incorporating risk in capital budgeting. Real Asset Valuation. Valuation Measuring Profitability The good (NPV)

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Capital Budgeting

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  1. Capital Budgeting • Real Asset Valuation and Profitability • NPV • IRR • MIRR • Payback • Cross-over rates • Capital Budgeting process • Cash flows that matter • WACC • Sensitivity analysis • Incorporating risk in capital budgeting

  2. Real Asset Valuation • Valuation • Measuring Profitability • The good (NPV) • The bad (IRR) • Cross-over rate • The ugly (Payback) • MIRR

  3. Real Asset Valuation • PV(asset)=PV(future cash flows from asset) • 3 elements: • CF=cash flow • Maturity=n • Interest rate=RAverage cost of moneyCost of capital? • What are the determinants of the firm’s value? • What would the firm’s value be if it had a perpetual cash flow? • Can the firm get value from other factors?

  4. The good: Net Present Value • Formula: • Where I/O is the initial outlay • It measures the $ profitability, taking into account time value of money and risk. It is often referred to as the “extra” $ available to the owners…any comments? • It assumes that cash flows are reinvested at R.

  5. NPV Calculation R=10% A B Year CF CF 0 -350 -250 1 50 125 2 100 100 3 150 75 4 200 50

  6. NPV Calculation • For A: NPV(A)=27.4 • For B: NPV(B)=36.78

  7. The Bad: Internal rate of return • IRR is the minimum return (yield) on a real investment so that the present value of the future cash flows is equal to the I/O--It is the (break-even) rate that sets NPV equal to zero. • IRR=Additional cents on the $ invested • It assumes that CFs are reinvested at IRR • It might include several (irrelevant) solutions • It might provide contradictory results with NPV

  8. IRR Calculation R=10% A B A-B Year CF CF CF 0 -350 -250 -100 1 50 125 -75 2 100 100 0 3 150 75 75 4 200 50 150 IRR 12.91% 17.80% 8.1%???

  9. NPV vs. IRR • NPV and IRR 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

  10. Another Example – Non-conventional Cash Flows • Suppose an investment will cost $90,000 initially and will generate the following cash flows: • Year 1: 132,000 • Year 2: 100,000 • Year 3: -150,000 • The required return is 15%. • Should we accept or reject the project?

  11. NPV Profile IRR = 10.11% and 42.66%

  12. Summary of Decision Rules • The NPV is positive at a required return of 15%, so you should Accept • If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject • You need to recognize that there are non-conventional cash flows and look at the NPV profile

  13. IRR and Mutually Exclusive Projects • Mutually exclusive projects • If you choose one, you can’t choose the other • Example: You can choose to attend graduate school at either Harvard or Stanford, but not both • Intuitively you would use the following decision rules: • NPV – choose the project with the higher NPV • IRR – choose the project with the higher IRR

  14. Example With Mutually Exclusive Projects The required return for both projects is 10%. Which project should you accept and why?

  15. NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

  16. Conflicts Between NPV and IRR • 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 • IRR is unreliable in the following situations • Non-conventional cash flows • Mutually exclusive projects

  17. Summary – Discounted Cash Flow Criteria • Net present value • Difference between market value and cost • Take the project if the NPV is positive • Has no serious problems • Preferred decision criterion • Internal rate of return • Discount rate that makes NPV = 0 • Take the project if the IRR is greater than the required return • Same decision as NPV with conventional cash flows • IRR is unreliable with non-conventional cash flows or mutually exclusive projects • Payback period • Length of time until initial investment is recovered • Take the project if it pays back within some specified period • Doesn’t account for time value of money and there is an arbitrary cutoff period

  18. A Better Method: MIRR • Assume that Cash Flows are reinvested at the opportunity cost rate. • Bring all positive cash flows to the future=FV(Positive cash flows) • Bring all negative cash flows to the present =PV(Negative cash flows) • Then, • FV(Positive cash flows)= PV(Negative cash flows) x FVIF(n, MIRR)

  19. Example: MIRR • For Project A • Do Project B… R=10% A B Year CF CF 0 -350 -250 1 50 125 2 100 100 3 150 75 4 200 50

  20. The Ugly: Payback • Payback: length of time until the sum of an investment’s cash flows equals its cost. Year CF Cumulated CF 1 200 200 2 400 600 3 600 1200 I/O=$1,000 Payback=2 year + 400/600=2 2/3 year • No time value • No risk • Focuses on liquidity; thus, biased against long term projects • What is the most common measure of profitability in corporate America?

  21. Payback Calculation R=10% A B Year CF CF 0 -350 -250 1 50 125 2 100 100 3 150 75 4 200 50 Payback 3.25 years 2.33 years

  22. Capital Budgeting • Capital budgeting • Cash flow • Start form nothing=CFA • Expand or Replace=ΔCFA • Cost of capital

  23. Cash Flows That Matters... • Stand-alone principle: • Cash flow that matters in a new project: Cash flow from assets • Cash flow that matters in a replacement or expansion project: Incremental Cash flow from assets • Also,

  24. Incremental Cash Flow Analysis (case of replacement or expansion Project) Δ revenues + Δ costs (“-” for an increase in costs, “+” for savings in costs) + Δ Depreciation (“+” for an increase in DPR, “-” for a decrease in DPR) + Δ taxes (“-” for an increase in taxes, “+” for savings in taxes) + Δ NWC sp.(“-” for an increase in NWC sp., “+” for a decrease in NWC sp.) + Δ Fixed Assets spending (“-” for an increase in FA sp., “+” for a decrease in FA sp.) --------------------------------------- Incremental (Δ )Cash flow from assets

  25. Costs that matter…or not • Sunk costs (R&D, consulting fee) • Opportunity cost and externalities: cost of using a rented vs. own building space (opportunity cost: you could lease/rent it for a certain amount of dollar) • NWC: it is recovered at the end (2 techniques) • Terminal value (the value at the end…) • Initial outlay • Financing costs • Are they included in “cash flow from assets”? • Would you consider them in evaluating the profitability of a project? Why? How?

  26. More Complicated Case:REPLACEMENT PROJECT Ex: you are looking at replacing an old processing system with a new one. Installation costs of the new system (net of taxes) are $485,000, which is going to be depreciated to zero over five years. The new system can be scrapped for $60,000. The pre-tax operating cost savings are $100,000 per year. also, the new system requires an initial net working capital injection of $50,000. The tax rate is approximately 34%. The discount rate for this project is 15%. Go or no-go with the replacement?

  27. Original Machine Initial cost = 100,000 Annual depreciation = 9000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000 Salvage in 5 years = 10,000 New Machine Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation Required return = 10% Tax rate = 40% An other replacement Problem

  28. Cost Cutting… • Your company is considering a new computer system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%.

  29. More Complicated Case:EXPANSION PROJECT Ex: HEP a tech company is looking at a full scale production of its “atomic filtration” device (AFD). The marketing department estimates that an additional 15,000 units can be sold at $2,000 a piece. Additional Equipment needed would cost $9.5 million and $0.5 million in installation. This equipment can be depreciated straight line in 5 years to zero. Initial net working capital injection is $4 million. The life of the project is 4 years at the end of which it can be sold for $2 million. Variable cost are not changing from prior the expansion—i.e., 60% of sales. However, fixed costs will increase at least by $5 million a year. The marginal tax rate is approximately 40%. The discount rate for this project is 15%. Go or no-go with the expansion?

  30. Sensitivity Analysis/ Simulation • A probability function for NPV • Simulation  Value at risk? • Sensitivity analysis  What variables really matter? • Crystal ball example • Real Options

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