Capital Budgeting Essay Example

Capital Budgeting Essay Example Capital Budgeting Essay Capital Budgeting Essay Corporate Finance Capital Budgeting Course Outline CAPITAL BUDGETING Course outline Key Principles in Capital Budgeting: Criteria for Investment Projects Net Pesent Value Internal Rate of Return Payback Profitability Index Finding Cash Flows Maria Ruiz 1 Financial Management Financial management is largely concerned with financing, dividend and investment decisions of the firm with some overall goal in mind. Corporate finance theory has developed around the goal of shareholder wealth maximization. Financing decisions deal with the firm’s optimal capital structure in terms of debt and equity. Dividend decisions relate to the form in which returns generated by the firm are passed on to equity-holders. Investment decisions deal with the way funds raised in financial markets are employed in productive activities to achieve the firm’s overall goal. Capital budgeting is primarily concerned with sizable investments in long-term assets. These assets may be tangible (property, plant or equipment) or intangible ones such as new technology, patents or trademarks. They are generally long-lived projects with their benefits or cash flows spreading over many years. As such, capital budgeting decisions have a major effect on the value of the firm and its shareholder wealth. Maria Ruiz Capital Budgeting Capital Budgeting: An Introduction Capital budgeting: one of the most important functions a financial manager must perform, required by the strategic planning and expansion of operations by allocating financial resources for the acquisitions of physical resources that will produce incremental future cash-flow and create value for shareholders: Corporate investment projects: Replacement decisions o maintain the business made without detailed analysis for cost reduction or efficiency purposes – fairly detailed analysis Expansion of existing products or markets – complex decision process that require an explicit forecast of future demand, detailed analysis Expansion into new products or markets similar detailed analysis Regulatory, safety and/or environmental projects – mandatory investments for many industries, and often accom pany new revenue producing projects The same ideas also apply to personal investment decisions (for example buying a car vs. leasing it, renting an apartment vs. uying one). Maria Ruiz 2 Capital Budgeting Key Principles Rule 1 : Cash flows after taxes, not net income, is the proper basis for analysis Only the incremental cash flows should form part of an investment decision Sunk Costs should not be included in the analysis Only incremental Cash Flows are analyzed: externalities should be included (i. e. cannibalization) Rule 2 : Cash Flow are based on Opportunity costs Rule 3 : Timing of cash flows is critical Rule 4 : Cash Flows are analyzed on an after-tax basis Rule 5: Financing costs are already reflected in the projects required rate f return Maria Ruiz Key concepts Sunk costs: Cost that has already been incurred RD expenses are $10,000 to-date for your project, and you plan to spend another $20,000, making $30,000 in all. What are cash flows for the project? Opportunity cost: what a resource is worth in its next-best use A company uses idle property, what should it use as the investment outlay? (pruchase price, current market value, nothing ? ) Incremental cash flows: difference between projected cash flows with and without the project Maria Ruiz 3 Key concepts Externality: effect of an investment on other things besides the investment itself Ilustration of Cannibalism: A proposed project will generate $10,000 in revenue, but will causes another product line to lose $3,000 in revenues. How much cash flow should the company consider? Conventional vs. Non conventional cash flows: Conventional: initial outflow followed by a series of inflows Non conventional: different Maria Ruiz Illustration: Underutilized Resources A project uses an existing (non-cancelable) leased warehouse with a remaining life of 20 years, and total annual rent of $100,000 The warehouse is rojected to remain 50% utilized, unless your project is undertaken The lease prohibits sub-leasing The current project is making a loss Your project will use 25% of the warehouse What should the project be charged? Maria Ruiz 4 Illustration: Underutilized Resources SEVERAL POSSIBLE SOLUTIONS: Choose one 1. The original project currently using the warehouse is making a loss: â€Å"Charg e the full $100,000 /year so the company can recover the very real warehousing costs. † 2. Half the warehouse is available: The project should be charged the full $50,000 /year if it needs to use it. A portion of the warehousing costs will not be charged-out otherwise. † 3. 4. The project is going to use only 25% of the space. â€Å"Charge $25,000 /year. † The charge should be proportioned according to revenues generated by each project: â€Å"The old project’s revenues = $9,000,000, and the new project has projected revenues = $1,000,000, so the charge is 10%, or $10,000/year. † 5. 6. This is a new project, so give it a sporting chance: The project should be charged nothing. † The original lease was entered into when warehouse space was cheap, but now space is twice what it was: â€Å"The market value of the leased warehouse is now $200,000, and the project should take its proper share of that amount. † Maria Ruiz Capital Budgeting Classification of projects Independent versus Mutually Exclusive Projects: An independent project is one the acceptance or rejection of which does not directly eliminate other projects from consideration or affe ct the likelihood of their selection. Two or more projects that cannot be pursued simultaneously, the acceptance of one prevents the acceptance of the alternative proposal, are mutually exclusive they involve ‘either-or’ decisions Mutually exclusive projects can be evaluated separately to select the one which yields the highest net present value to the firm. A contingent project is one the acceptance or rejection of which is dependent on the decision to accept or reject one or more other projects. Contingent projects may be complementary or substitutes Maria Ruiz 5 Capital Budgeting Project Sequencing The sequencing of projects is a strategic issue, it creates options on one or more projects as the direct result of undertaking another (previous) project. Old Suppose a firm is evaluating projects to produce a number of consumer products It may be advantageous to implement projects sequentially rather than in parallel. If taken in parallel, management would spend the resources and the value of the option not to spend in case of failure is lost. Extreme case example is RD: The source of value is the options created to undertake other projects. Interproject options are created whenever management makes an investment that places the firm in a position to use new technology to enter a different industry Maria Ruiz Choosing between Investment Projects Investment decision criteria Net Present Value Internal Rate of Return Payback Normal Discounted Profitability Index Maria Ruiz 6 Capital Budgeting The Net Present Value (NPV) NPV : difference between the initial investment and the sum of the present values of cash flows that are generated: NPV0 = ? I 0 + ? t =1 T CFt (1 + r ) t If the project involves investment in installments spread over N years, then the NPV is: NPV0 = ? t =0 N T ? It CFt +? t t (1 + r ) t =1 (1 + r ) A project’s NPV signifies the increase in wealth to stockholders, if the project is undertaken. We apply the DCF model to corporate decision making and we use the Net Present Value (NPV) Rule to evaluate projects and decide which one we should adopt. Maria Ruiz Capital Budgeting Examples NPV Rule 1: Accept the project if its NPV gt; 0 It indicates that only projects that increase the owners’ wealth should be undertaken, ie a project is accepted only if its PV gt; Cost Similarly, a stock or bond is purchased if its PV is greater than its market price (its â€Å"cost†) Example: A wind-power plant will cost â‚ ¬ 50 million to build. The plant will generate annual cash flows of 16 per year for 4 years, plus another 20 millions the fith year. The 6th year, the plant will be scrapped at a cost of 2 millions. What is the NPV of the project if the opportunity cost of capital is 10%? What if the opportunity cost of capital is 20%? Maria Ruiz 7 Capital Budgeting Examples NPV Rule 2: If the projects are not mutually exclusive, all projects for which NPV gt; 0 should be undertaken. If the projects are mutually exclusive, then the project with the highest NPV should be chosen. Example: You are considering buying a network server with a useful life of three years. Two alternatives exist. Model A costs â‚ ¬ 250,000 and will lead to a productivity improvement of â‚ ¬ 110,000 per year for 3 years. Model B costs â‚ ¬ 200,000 and will generate a productivity gain of â‚ ¬ 85,000 for 4 years. Which model would you choose if the cost of capital is 8% for this project? Maria Ruiz Capital Budgeting NPV Profile The NPV profile is convex in a simple relationship between NPV and IRR There are other profiles Maria Ruiz 8 Capital Budgeting Internal Rate of Return (IRR) Internal Rate of Return (IRR) : is the discount rate that equates the NPV of the investment project to zero. In other words, IRR is the solution to the following equation ? T CFt ? (1 + IRR) t ? t =1 ? ? ? I0 = 0 ? ? Decision rule Go ahead with the project if IRR is higher than the (explicit) opportunity cost of capital (i. . , the return on an alternative investment, possibly a financial asset, with the same amount risk) or the implicit WACC. When there are multiple investment projects, you should choose the project with the highest IRR. However, other than the particular case of a positive outcome one period after initial investment, there are important caveats regarding the IRR criterion that you should be awar e of. Maria Ruiz Internal Rate of Return 2500 2000 1500 NPV (,000s) 1000 500 0 IRR -1000 -1500 -2000 Discount rate (%) Maria Ruiz 10 0 -500 40 10 20 30 50 60 70 80 90 9 Capital Budgeting Internal Rate of Return (IRR) Decision rule If IRR gt; discount rate, go ahead with the project Example: A wind-power plant will cost â‚ ¬ 50 million to build. The plant will generate annual cash flows of 16 per year for 4 years, plus another 20 millions the fith year. The 6th year, the plant will be scrapped at a cost of 2 millions. If the cost of capital is 10%, would you go ahead with the project? Maria Ruiz NPV and IRR (CFA 2009) Maria Ruiz 10 Capital Budgeting Ranking Conflicts between NPV and IRR IRR and NPV criteria may not lead to the same conclusion in the case of mutually exclusive projects. NPV rule easily chooses among mutually exclusive projects, IRR does not. lliustration: Which of the following mutually exclusive projects should you choose? Year Project A 0 1 –500 590 2 0 3 0 Year 0 1 2 3_ Project B –500 50 50 620 (see graph next page) Maria Ruiz Capital Budgeting Ranking Conflicts between NPV and IRR Different Cash Flow patterns may lead to a conflict of ranking Pitfalls of IRR Difficulty in Evaluating Mutually Exclusive Projects 250 200 150 100 NPV 50 0 -50 -100 -150 -200 Rate of Return Project A Maria Ruiz 0% 5% 10% 15% 20% 25% 30% Project B 11 Capital Budgeting Ranking Conflicts between NPV and IRR IRR and NPV criteria may not lead to the same conclusion in the case of mutually exclusive projects. NPV rule easily chooses among mutually exclusive projects, IRR does not. lliustration: Which of the following mutually exclusive projects should you choose? Year Project A 0 1 –500 590 2 0 3 0 Year 0 1 2 3_ Project B –500 50 50 620 Choose A Choose B A neither IRR Criterion IRRA=18% gt; IRRB=14% NPV Criterion if OCC lt; 12% then: NPVA lt; NPVB if 12% lt; OCC lt; 18% then: NPVA gt; NPVB if OCC gt; 18% then: NPVB lt; NPVA