Capital budgeting

6 Corporate Financial Management 2e Emery Finnerty Stowe Business Investment Rules

Learning Objectives Understand the practice of capital budgeting as it is practiced in most corporations. Understand how sound methods of evaluating business investments can be applied to both proposed projects and current operations.

Focus on Principles Valuable Ideas Look for new ideas to use as a basis for capital budgeting projects will create value Comparative Advantage Look for capital budgeting projects that will use the firm’s comparative advantage to create value. Incremental benefits Identify and estimate the expected future cash flows for a capital budget project on an incremental basis.

Focus on Principles Risk-Return Trade-Off Incorporate the risk of a capital budgeting project into its cost of capital— the project’s required return. Time-Value-Of-Money Measure the current value a capital budgeting project will create, its NPV.

Focus on Principles Options Recognize the value of options, such as the option to delay, expand, or abandon a project. Two-Sided Transactions Consider why the other party to a transaction is willing to participate. Signaling Consider the products and actions of competitors.

Chapter Outline 6.1 The Capital Budgeting Process 6.2 Net Present Value 6.3 Internal Rate of Return 6.4 Using the NPV and IRR Criteria 6.5 Other Widely Used Capital Budgeting Criteria 6.6 Business Investment in Practice

6.1 The Capital Budgeting Process The process can be broken down into five steps as a project moves from idea to reality: Generating ideas for capital budgeting projects. Reviewing existing projects and facilities. Preparing proposals. Evaluating proposed projects and creating the capital budget. Preparing appropriation requests.

Generating ideas for capital budgeting projects Research and Development Division Management Plant Management Production Management Strategic Planning ideas ideas ideas ideas ideas ideas ideas ideas

Classifying Capital Budgeting Projects Maintenance Projects Cost Savings / Revenue Enhancement Capacity Expansions in Current Business New Products and New Businesses Projects Required by Government Regulation or Firm Policy

Preparing Proposals Generally, the originator presents a written proposal. Most large firms use standard forms, and these are typically supplemented by written memoranda. There may be consulting studies prepared by outside experts.

Capital Budgeting and the Required Return The required return is the minimum rate of return that you need to earn to be willing to make an investment. It is the rate of return that compensates you for the risk of the expected future cash flows. It depends on the use of the money not the source.

6.2 Net Present Value Recall that an asset’s net present value (NPV) is the difference between what it is worth and what it costs. The major difficulty of finding a project’s NPV rests with the need to see situations differently from other people in the market.

NPV example Suppose you notice a run-down house for sale in your neighborhood. The price is $80,000 as the house stands today. The house requires $40,000 worth of repairs. The repairs would take a year to complete. Fixed up, you could sell the house in one year for $135,000. Having a slightly better neighborhood increases the value of your own home by $5,000.

NPV example If your discount rate is 10%, the net present value of the project to you is $7,273: The net present value of the project to someone who does not live in the neighborhood is $2,727:

6.3 Internal Rate of Return The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero. The internal rate of return is the project’s expected return. Undertake a project if the IRR exceeds r , the project’s cost of capital.

IRR example 7.03 A project costs $10,000 and is expected to generate cash flows of $2,100 each year for six years. What is the project’s IRR? CALCULATOR SOLUTION Data Input Function Key N I PV PMT FV 6 10,000 – 2,100 0

6.4 Using the NPV and IRR Criteria Most of the time NPV and IRR are both valuable guides to making decisions. There are occasions, however, where NPV and IRR disagree. When in doubt, you can trust the NPV.

NPV Profile An NPV profile plots the project’s NPV as a function of the discount rate. It shows both the NPV and the IRR of the project. It can be used to identify the range of cost of capital at which the project would add value to the firm.

NPV Profile: Example Cash Flow Initial Investment Cash Flow in years 1 to 5 Cash Flow in years 6 to 9 Cash Flow in year 10 - $3,985,000 $806,000 $926,000 $1,151,000 Consider a 10-year project with these cash flows:

NPV Profile NPV ($ thousands) Discount Rate The project has a positive NPV at discount rates less than 16.95% And a negative NPV at discount rates more than 16.95% IRR 16.95%

When IRR and NPV Can Disagree Mutually exclusive Capital Budgeting Projects

When IRR and NPV Can Disagree Consider a firm that needs to buy a new heating system. They only need one. The choice is down to two systems: System A has high up-front costs and low maintenance costs. System B is inexpensive to install, but has high maintenance costs. Either system will offer savings over the current system.

When IRR and NPV Can Disagree The current system costs $400 per year to operate. The current system can be sold for $400 at time 0. The costs to install and operate the two alternative systems are shown below -400 -350 -300 -250 -200 -600 B -50 -50 -50 -50 -50 -1,000 A 5 4 3 2 1 0

When IRR and NPV Can Disagree Project A has a much higher NPV Project B has a higher IRR $182 68% 0 50 100 150 200 -200 B $573 51% 350 350 350 350 350 -600 A NPV IRR 5 4 3 2 1 0

When IRR and NPV can Disagree The incremental costs (after taking into account that the current system costs $400 per year to run) to install and operate the two alternative systems are shown below. The table also shows the IRRs and the NPV calculated at a discount rate of 15% $182 68% 0 50 100 150 200 -200 B $573 51% 350 350 350 350 350 -600 A NPV IRR 5 4 3 2 1 0

If the discount rate is less than 45%, project A is the best choice. If the discount rate is more than 45%, project B is the best choice. If the discount rate is more than 68% don’t take A or B rate -over Cross 45%

Non-Conventional Projects Consider a proposal to mine asbestos in an ecologically sensitive area. The project will require investment of $5,200,000 today, generate 12.3 million cash inflow at the end of year one and require shut down and reclamation expenses of $7.25 million at the end of year 2. Year 0 1 2 Cash Flow ($5,200,000) $12,300,000 ($7,250,000)

Non-Conventional Projects At a discount rate of 12%, the project has a zero NPV. Does that mean that if our cost of capital is 10% that we should start the project?

NPV Profile of Non-Conventional Projects Discount Rate NPV IRR 2 = 25% Here we see that the project actually has two IRRs: 12% and 25% You have to be careful interpreting IRR. IRR 1 = 12%

IRR on Balance IRR is widely used in practice. More widely used than NPV actually. Many people prefer the intuitive feel of the IRR rule.

6.5 Other Widely Used Capital Budgeting Criteria Profitability Index Payback Discounted Payback Average Rate of Return Return on Investment Urgency

Profitability Index Decision Rule: Undertake the project if PI > 1.0 PI PV of Future Cash Flows Initial Investment NPV Initial Investment = = + 1

Profitability Index Perma-Filter is considering two mutually exclusive one-year projects, whose cash flows are shown below. The cost of capital for either project is 12%. Compute the NPV and the PI for each project and indicate which one should be undertaken. Project CF 0 CF 1 Alpha Beta ($1,000) ($8,000) $1,200 $9,200

Profitability Index Project Alpha Project Beta Year 0 Cash Flow Year 1 Cash Flow ($1,000) $1,200 ($8,000) $9,200 NPV @ 12% PI $71.43 1.071 $214.29 1.027

Profitability Index PI measures the NPV per dollar invested. For independent projects, the PI method yields conclusions identical to the NPV method. For mutually exclusive projects, differences in project size can lead to conflicting conclusions. Use the NPV method. PI is useful when there is capital rationing.

Payback Method The payback is the length of time it takes for the project’s cash flows to equal its investment. Decision Rule: Undertake the project if the payback is less than a preset amount of time.

Discounted Payback Method The discounted payback is the length of time it takes for the project’s discounted cash flows to equal its investment. Decision Rule: Undertake the project if the discounted payback is less than a preset amount of time.

Payback and Discounted Payback The cash flows for two mutually exclusive projects X and Y are shown on the next slide. The cost of capital for each project is 12%. Compute the NPV, the payback, and the discounted payback for each project. Which project should the firm choose?

Payback and Discounted Payback Year Project X Project Y 0 1 2 3 4 ($8,000) $4,000 $4,000 $2,000 $2,000 ($8,000) $2,000 $2,000 $4,000 $6,000

Payback and Discounted Payback for Project X Discounted Year Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow 0 1 2 3 4 ($8,000) $4,000 $4,000 $2,000 $2,000 ($8,000) ($4,000) $0 ($8,000) $3,571 $3,189 $1,424 $1,271 ($8,000) ($4,429) ($1,240) $184

Payback and Discounted Payback for Projects X and Y * Discount rate = 12% Project X Project Y Payback Discounted Payback* NPV* 2 years 2.87 years $1,455 3 years 3.46 years $2,040

Payback and Discounted Payback Payback ignores the time value of money. Both require an arbitrary cutoff value. Payback ignores risk differences between projects. Both ignore cash flows after the payback period.

Average Rate of Return (ARR) The ARR method distorts all cash flows by averaging them over time. It ignores the time value of money. It is a useless method. ARR Average Cash Flow Average Amount Invested =

Return on Investment (ROI) ROI is sometimes defined as the Internal Rate of Return (IRR), and sometimes as the Average Rate of Return (ARR). It is also defined in terms of accounting income instead of cash flows. If the definition differs from that of the IRR, it should not be used. Recall the drawbacks of the IRR method.

Urgency This method says “invest in the project when you absolutely have to.” Replacement decisions: replace asset after it has broken down! It ignores planning ahead. “A pound of prevention is worth a pound of cure!”

6.6 Capital Budgeting in Practice Most firms used more than one method for capital budgeting project evaluation. The NPV profile is the most useful item. It provides the most complete view of the project. A process for appropriating capital after the projects have been selected must be created by the firm. Review of project performance must be done periodically.

Summary The capital budgeting process and the investment criteria used to make capital budgeting decision are critical because firms are effectively defined by the products and services they provide using their capital assets.

Capital budgeting

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Capital budgeting