Capital Budgeting

Capital Budgeting - Analysis of Cashflows MFIN 6664

Capital Budgeting • evaluate potential projects with an evaluation methodology • such as net present value (NPV) or internal rate of return (IRR) • CFt is the expected cashflow in period t • r is the discount rate, • or required return, • or opportunity cost of capital, • or hurdle rate

Capital Budgeting • To calculate IRR: • solve for IRR, the discount rate that gives NPV=0 • Both NPV and IRR are extremely common methods • for project evaluation in the real world

Cashflows • To evaluate projects, need estimates of the cashflows (CFts) expected • First step is often development of pro forma income statements for the project • Even though we will adjust the accounting numbers in the end, it is common to do this because: • Common for financial info to be presented in accounting format • Many people are used to thinking terms of accounting numbers • You want to see what effect the project may have on the accounting net income for the firm (i.e “How will our numbers look if we take this project?”)

Simple Income Statement

Estimating the top lines of the pro forma income statement is extremely important • Estimates of revenues and operating expenses • Must be done via your knowledge of the business • No “financial model” to do this • May be based on past experience with this type of project, or knowledge of the business and industry • After that, must also estimate interest, depreciation, tax rate to get down to net income

Cashflows • Does net income represent the cashflow for the year from the project? • NO. • There are various non-cash items in the income statement that must be accounted for • Capital expenditures are cashflow that must be paid by firm, but do not show up on income statement • Also, in capital budgeting it is typical for interest not to be included as a cashflow • The cost of debt is usually accounted for in the discount rate used • The operating cashflow to the project is often represented as the Free Cash Flow to the Firm (FCFF)

Free Cash Flow to the Firm FCFF = Net Income + Depreciation - Capital Expenditures - Change in non-cash Working Capital + Interest (1 – tax rate)

Free Cash Flow to the Firm • By combining the net income and interest parts, can also write FCFF as: FCFF = EBIT (1-tax rate) + Depreciation - Capital Expenditures - Change in non-cash Working Capital

The FCFF represents the estimated cashflow that will be generated each period by the project • Cashflow available to be paid out to investors (both debtholders and shareholders) • It is the cashflow to the firm overall (equity + debt) • Part of FCFF will go to pay interest/principal on debt and the residual belongs to the shareholders

Cashflows • Other adjustments may be necessary to get the final cashflow for analysis purposes • All incremental cashflows must be included (and all non-incremental cashflows must be excluded) • For example: • Sunk costs should be ignored • All effects on other parts of the firm should be included • Opportunity costs should be included • After adjustment for any other effects, the FCFF can then be used to estimate NPV (or IRR)

Example • Firm thinking of launching new product • Initial cost = $2 million for new equipment • Estimated sales in first year = $3 million • Sales expected to increase by 5% per year • Fixed costs of production will be $1.5 million/year • Estimated that variable costs will be 40% of sales • Assume depreciation on new equipment will be simple straight line over 10 years • i.e. ignore CCA rules in example • Depreciation will be $200,000 per year • Accounts receivable will be 10% of sales each year • Accounts payable will be 15% of costs (fixed+variable) each year • Inventory will equal 5% of sales each year • IN 8 years, production will be shut down, all accounts payable/receivable paid or collected, inventory sold, and equipment sold for $400,000 • Firm’s tax rate is 35% • The firm requires a return of 12% on this project. • Calculate NPV and IRR SEE SPREADSHEET FOR SOLUTION

Capital Budgeting - Analysis of Cashflows