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CHAPTER 11 The Basics of Capital Budgeting. Should we build this plant?. Steps in Capital Budgeting. 1. Estimate Cash flows. 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC. Basic Framework for Decisions.
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CHAPTER 11The Basics of Capital Budgeting Should we build this plant?
Steps in Capital Budgeting 1. Estimate Cash flows. 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
Basic Framework for Decisions • Cash flow Evaluation • The Tough Part • Benefits & Costs • Risk & Return • Cost of capital is function of project risk • Mutually Exclusive Projects & Independent Projects
An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.
Normal Cash Flow projects Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.
Decision Rules • Payback Period • The number of years required to recover a project’s cost • A Very Simple, but Imprecise measure • Net Present Value (NPV) • NPV = Present Value of all cash flows • Accept positive NPV projects • Theoretically the best approach
Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
Decision Rules • Internal Rate of Return (IRR) • Discount rate for which NPV = 0 • IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. • IRR is the same YTM. • Not suitable for mutually exclusive projects
Two Simple Projects • Project S and Project L • Cash Flows: S L • Year 0 -100 -100 • Year 1 10 70 • Year 2 60 50 • Year 3 80 20
Calculator Solution for Project L Enter in CFLO for L: -100 10 60 80 10 CF0 CO1 CO2 CO3 NPV = 18.78 = NPVL I NPVS = $19.98 IRRL = 18.13 IRRS = 23. 56
NPV Profiles Enter CFs in CFLO and find NPVL and NPVS at different discount rates: NPVS 40 29 20 12 5 NPVL 50 33 19 7 k 0 5 10 15 20 (4)
NPV ($) k 0 5 10 15 20 NPVL 50 33 19 7 (4) NPVS 40 29 20 12 5 Crossover Point = 8.7% S IRRS = 23.6% L Discount Rate (%) IRRL = 18.1%
NPV and IRR always lead to the same accept/reject decision for independent projects NPV ($) IRR > k and NPV > 0 Accept. k > IRR and NPV < 0. Reject. k (%) IRR
Modified IRR (MIRR) MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.
$158.1 (1+MIRRL)3 $100 = MIRR for Project L (k = 10%) 0 1 2 3 10% -100.0 10.0 60.0 80.0 10% 66.0 12.1 10% MIRR = 16.5% 158.1 -100.0 TV inflows PV outflows MIRRL = 16.5%
Chapter 12 - Cash Flow Estimation • What cash flows to use? • Incremental After-tax cash flows • Cash flows only • Opportunity costs & sunk costs • Side effects, externalities • Change in working capital • Ignore financing charges • Depreciation
Proposed Project - Minicase Ch. 12 • Cost: $200,000 + $10,000 shipping + $30,000 installation. • Depreciable cost $240,000. • Inventories will rise by $25,000 and payables will rise by $5,000. • Economic life = 4 years. • Salvage value = $25,000. • MACRS 3-year class.
Incremental gross sales = $250,000. • Incremental cash operating costs = $125,000. • Tax rate = 40%. • Overall cost of capital = 10%.
Set up without numbers a time line for the project CFs. 0 1 2 3 4 Initial Outlay OCF1 OCF2 OCF3 OCF4 + Terminal CF NCF0 NCF1 NCF2 NCF3 NCF4
Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • NO. This is a sunk cost. Focus on incremental investment and operating cash flows.
If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis? • Yes. The effects on the other projects’ CFs are “externalities”. • Net CF loss per year on other lines would be a cost to this project. • Externalities will be positive if new projects are complements to existing assets, negative if substitutes.
Net Investment Outlay at t = 0 (000s) Equipment Freight + Inst. Change in NWC Net CF0 ($200) (40) (20) ($260) DNWC = $25,000 - $5,000 = $20,000.
Annual Depreciation Expense (000s) Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis = Depr. $ 79 108 36 17 $240
Year 1 Operating Cash Flows (000s) Year 1 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107
Year 4 Operating Cash Flows (000s) Year 1 Year 4 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107 $125 (17) $108 (43) $ 65 17 $ 82
Net Terminal Cash Flow at t = 4 (000s) Salvage value Tax on SV Recovery on NWC Net terminal CF $25 (10) 20 $35
What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.
Project Net CFs on a Time Line 0 1 2 3 4 (260)* 107 118 89 117 Enter CFs in CFLO register and I = 10. NPV = $81,573. IRR = 23.8%. *In thousands.
What is the project’s MIRR? (000s) 0 1 2 3 4 117.0 TV = 500.1 (260)* 107 118 89 (260) MIRR = 17.8%
If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold and the incremental CFs would be the changes from the old to the new situation.
Revenues. • Costs. • The relevant depreciation would be the change with the new equipment. • Also, if the firm sold the old machine now, it would not receive the salvage value at the end of the machine’s life.
What is cash flow estimation bias? • CF’s are estimated for many future periods. • If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK). • Studies show that forecasts often are biased (overly optimistic revenues, underestimated costs).
What steps can management take to eliminate the incentives for cash flow estimation bias? • Routinely compare CF estimates with those actually realized and reward managers who are forecasting well, penalize those who are not. • When evidence of bias exists, the project’s CF estimates should be lowered or the cost of capital raised to offset the bias.
What is option value? • Investment in a project may lead to other valuable opportunities. • Investment now may extinguish opportunity to undertake same project in the future. • True project NPV = NPV + value of options.
If 5% inflation is expected over the next 5 years, are the firm’s cash flow estimates accurate? • No. Net revenues are assumed to be constant over the 4-year project life, so inflation effects have not been incorporated into the cash flows.
Real vs. Nominal Cash flows • In DCF analysis, k includes an estimate of inflation. • If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. • This bias may offset the optimistic bias of management.
S and L are mutually exclusive and will be repeated. k = 10%. Which is better? (000s) 0 1 2 3 4 Project S: (100) Project L: (100) 60 33.5 60 33.5 33.5 33.5
S L CF0 -100,000 -100,000 CF1 60,000 33,500 Nj 2 4 I 10 10 NPV 4,132 6,190 NPVL > NPVS. But is L better? Can’t say yet. Need to perform common life analysis.
Note that Project S could be repeated after 2 years to generate additional profits. • Can use either replacement chain or equivalent annual annuity analysis to make decision.
Project S with Replication: Replacement Chain Approach (000s) 0 1 2 3 4 Project S: (100) (100) 60 60 60 (100) (40) 60 60 60 60 NPV = $7,547. Project L NPV = $6,190
EAA Solution • Project S • PV = Raw NPV = $4,132. • n = Original project life = 2. • k = 10%. • Solve for PMT = EAAS = $2,381. • Project L • PV = $6,190; n = 4; k = 10%. • Solve for PMT = EAAL = $1,953. • EAAS > EAAL so pick S.
If the cost to repeat S in two years rises to $105,000, which is best? (000s) 0 1 2 3 4 Project S: (100) 60 60 (105) (45) 60 60 NPVS = $3,415 < NPVL = $6,190. Now choose L.
Abandonment Option - Example Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Abandonment Value $5,000 3,100 2,000 0 NPV(no)= -$123, NPV(2)= $215, NPV(1) = -$273.
Chapter 13 - Risk Analysis & Real Options • Types of risk • Project risk and capital structure • Risky outflows • Effects of abandonment possibilities • Real options • Optimal capital budget
Risk Analysis & Types of Risk • Risk Analysis • Historic Data or Subjective Assessment? • Types of Risk • Stand-alone risk, Corporate risk, Market (or beta) risk • Measured by sNPV, sIRR, beta. • Will taking on the project increase the firm’s and stockholders’ risk?
How is each type of risk used? • Market risk is theoretically best in most situations. • However, creditors, customers, suppliers, and employees are more affected by corporate risk. • Therefore, corporate risk is also relevant.
Stand-alone risk is easiest to measure, more intuitive. • Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. • If the project is highly correlated with the economy, stand-alone risk also reflects market risk.
What is sensitivity analysis? • Shows how changes in a variable such as unit sales affect NPV or IRR. • Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. • Answers “what if” questions, e.g. “What if sales decline by 30%?”
What is scenario analysis? • Examines several possible situations, usually worst case, most likely case, and best case. • Provides a range of possible outcomes.
What is a simulation analysis? • A computerized version of scenario analysis which uses continuous probability distributions. • Computer selects values for each variable based on given probability distributions and calculates NPV and IRR. • Process is repeated many times (1,000 or more) and Probability distribution of NPV and IRR produced.