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College of Business Administration University of Pittsburgh Capital Budgeting: Investment Criteria

BUSFIN 1030 Introduction to Finance

Capital Budgeting Decisions


Examples o decisions addressed: What products should the firm sell? In what markets should the firm compete? What new products should the firm introduce? !oles o managers: Identify and invest in products and business acquisitions that will maximize the current market value of equity. Learn to identify which products will succeed and which will fail. he capital markets will send the firm si!nals about how well it is doin!.

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Net "resent #alue $N"#%


he net present value is the difference between the market value of an investment and its cost.

NPV = - Cost + PV(Future Flows) NPV = - Cost + CF t t t=1 (1 + r )


T NPV = CF t t t =0 (1 + r ) T

#$% is a measure of the amount of market value created by undertakin! an investment pro&ect. he interest rate' r' will reflect the risk of the cash flows.

Finding t&e mar'et value o t&e investment (se discounted cash flow valuation )calculate present values*. +ompute the present values of future cash flows Net "resent #alue !ule $N"#%: (n investment s&ould )e accepted i t&e net present value is positive and re*ected i t&e net present value is negative+ "ositive N"# pro*ects create s&are&older value+

Using N"#
he marketin! department of your firm is considerin! whether to invest in a new product. he costs associated with introducin! this new product and the expected cash flows over the next four years are listed below. )-ssume these cash flows are 1../ likely*. he appropriate discount rate for these cash flows is "./ per year. 0hould the firm invest in this new product? +osts1 $romotion and advertisin! $roduction 3 related costs 5ther ,otal Cost -00+00 )2 million* 1..... 4..... 1.....

.ear . 1 " , 4

Cas& Flo/ )6.....* 2"..... 2"".... 2""7... 2"1....

"resent #alue Factor 1...

"#$Cas& Flo/% )6.....*

N"# 0

N"# Example
-ssume you have the followin! information on $ro&ect 81 Initial outlay 921'1.. :equired return ; 1./

-nnual cash revenues and expenses are as follows1 <ear :evenues =xpenses 1 21'... 27.. " "'... 1'... >raw a time line and compute the #$% of pro&ect 8.

,&e "a1)ac' !ule


"a1)ac' period: he len!th of time until the accumulated cash flows from the investment equal or exceed the ori!inal cost. We will assume that cash flows are !enerated continuously durin! a period. ,&e "a1)ac' !ule: -n investment is accepted if its calculated payback period is less than or equal to some pre9specified number of years. Example: +onsider the previous investment pro&ect analyzed with the #$% rule. he initial cost is 26.. million. It has been decided that the pro&ect should be accepted if the payback period is , years or less. (sin! the payback rule' should this pro&ect be undertaken?

.ear 1 " , 4

Cas& Flo/ 2"..... "".... ""7... "1....

(ccumulated Cas& Flo/ 2".....

Example: Calculating t&e pa1)ac' period: he pro&ected cash flows from a proposed investment are listed below. he initial cost is 27... What is the payback period for this investment?
.ear 1 " , Cas& Flo/ 21..... "..... 7..... (ccumulated Cas& Flo/ 21.....

(nal12ing t&e "a1)ac' !ule


+onsider the followin! table. pro&ects cost 2"7.... .ear 1 " , 4 he payback period cutoff is two years. ?oth

3ong 21..... 1..... 1..... 1.....

S&ort 2"..... 1..... .... ....

Which would you pick usin! the payback rule? Why?

What is the #$% of the lon! pro&ect? he short pro&ect? Which pro&ect would you pick usin! #$% rule? -ssume the appropriate discount rate is "./.

(dvantages and Disadvantages o t&e "a1)ac' !ule


(dvantages =asy to (nderstand

?iased toward liquidity

-llows for quick evaluation of mana!ers

-d&usts for uncertainty of later cash flows )by i!norin! them alto!ether*

Disadvantages

I!nores the time value of money

I!nores cash flow beyond the payback period

?iased a!ainst lon!9term pro&ects

,&e Discounted "a1)ac' !ule


Discounted "a1)ac' period: he len!th of time until the accumulated discounted cash flows from the investment equal or exceed the ori!inal cost. We will assume that cash flows are !enerated continuously durin! a period. ,&e Discounted "a1)ac' !ule: -n investment is accepted if its calculated discounted payback period is less than or equal to some pre9specified number of years. Example: +onsider the previous investment pro&ect analyzed with the #$% rule. he initial cost is 26.. million. he discounted payback period is , years. he appropriate discount rate for these cash flows is "./. (sin! the discounted payback rule' should the firm invest in the new product? Discounted (ccumulated Cas& Flo/

.ear 1 " , 4

Cas& Flo/ 2"..... 2"".... 2""7... 2"1....

"resent #alue Factor

(nal12ing t&e Discounted "a1)ac' !ule:

Involves discountin! as in the #$% rule

It does not consider the risk differences between investments. <et' we can discount with a hi!her interest rate for a riskier pro&ect.

Bow do you come up with the ri!ht discounted payback period cut9off? -rbitrary number.

(dvantages If a pro&ect ever pays back on a discounted basis' then it must have a positive #$%.

?iased toward liquidity =asy to understand

Disadvantages

Cay re&ect positive #$% pro&ects -rbitrary discounted payback period ?iased a!ainst lon!9term pro&ects

,&e Internal !ate o !eturn $I!!% !ule


D

Internal rate o return: he discount rate that makes the present value of future cash flows equal to the initial cost of the investment. =quivalently' the discount rate that !ives a pro&ect a zero #$%. I!! !ule: -n investment is accepted if its I:: is !reater than the required rate of return. -n investment should be re&ected otherwise. Calculating I!!: Like the < C' trial and error' financial calculators and financial spreadsheets are used to calculate the I::.

I!! Illustrated
Initial outlay ; 92".. <ear 1 " , 7. 1.. 17. +ash flow

Eind the I:: such that #$% ; . . ".. ; 9".. F 7. F 1 )1FI::* 1.. F 17. " )1FI::* )1FI::*, F 17. )1FI::*,

; 7. F 1.. )1FI::*1 )1FI::*"

1.

Comparison o I!! and N"#


I:: and #$% rules lead to identical decisions when the followin! conditions are satisfied.

Conventional Cas& Flo/s: he first cash flow )the initial investment* is ne!ative and all the remainin! cash flows are positive

"ro*ect is independent: - pro&ect is independent if the decision to accept or re&ect the pro&ect does not affect the decision to accept or re&ect any other pro&ect.

When one or both of these conditions are not met' problems with usin! the I:: rule can result.

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"ro)lems /it& t&e I!! !ule

Unconventional Cas& Flo/s: +ash flows come first and investment cost is paid later. In this case' the cash flows are like those of a loan and the I:: is like a borrowin! rate. hus' in this case a lower I:: is better than a hi!her I::

4ultiple rates o return pro)lem: he possibility that more than one discount rate makes the #$% of an investment pro&ect zero. Example: - strip9minin! pro&ect requires an initial investment of 26.. he cash flow in the first year is 2177. In the second year' the mine is depleted' but the firm has to spend 21.. to restore the land. >iscount :ate .../ 1.... ".... "7... ,.... ,,.,, 4.... #$% 927... 91.@4 9.."A .... ...6 .... 9..,1

Example 5: -ssume you are considerin! a pro&ect for which the cash flows are as follows1 <ear +ash flows . 92"7" 1 14,1 " 9,.,7 , "A7. 4 91... What is the I::? -t "7/ -t ,,.,,/ -t 4".A6/ -t 66.6@/ #$% ; #$% ; #$% ; #$% ;

"ro)lems /it& t&e I!! !ule $continued% 4utuall1 Exclusive "ro*ects


4utuall1 exclusive pro*ects1 If takin! one pro&ect means another pro&ect is not taken' the pro&ects are mutually exclusive. he one with the hi!hest I:: may not be the one with the hi!hest #$%. Crossover !ate: same. he discount rate that makes the #$% of the two pro&ects the

Finding t&e Crossover !ate


(se the #$% profiles ake the difference in the pro&ectsG cash flows each period and calculate the

I::.

=xample1 If pro&ect - has a cost of 27.. and cash flows of 2,"7 for two periods' while pro&ect ? has a cost of 24.. and cash flows of 2,"7 and 2".. respectively' the incremental cash flows are1
$eriod . 1 " I!! $ro&ect 97.. ,"7 ,"7 1D.4, $ro&ect ? 94.. ,"7 ".. "".1@ Incremental 91.. . 1"7 11.A

he crossover rate is 11.A/. -t this rate' #$%- ; #$%? ; 27..@1

(dvantages and Disadvantages o t&e I!! !ule


(dvantages

+losely related to #$% rule' often leadin! to the same decisions

=asy to understand and communicate

Disadvantages

Cay result in multiple answers with non9conventional cash flows.

Cay lead to incorrect decisions with mutually exclusive investment pro&ects.

#ot always easy to calculate.

College of Business Administration University of Pittsburgh Capital Budgeting: Investment Decisions


BUSFIN 1030 Introduction to Finance

!elevant Cas& Flo/s


!elevant Cas& Flo/s: the incremental cash flows associated with the decision to invest in a pro&ect.

Incremental Cas& Flo/s: -ny chan!es in the firmGs future cash flows that are a direct consequence of takin! the pro&ect. =xample1 Bonda +orporation

,&e Stand6(lone "rinciple: he evaluation of a pro&ect based on the pro&ectGs incremental cash flows. %iew each pro&ect as a HminifirmH with its own assets' revenues and costs.

(spects o Incremental Cas& Flo/s $7&ic& costs s&ould )e included in incremental cas& lo/s8% Sun' Costs: - cash flow already paid or already promised to be paid+

9pportunit1 Costs: -ny cash flow lost by takin! one course of action rather than another.

Side E ects: $ro&ects often hurt or help one another Erosion: :evenues !ained by a new pro&ect at the expense of the firmGs other products or services.

Net 7or'ing Capital: In all capital bud!etin! pro&ects we will assume that net workin! capital is recovered at the end of the pro&ect.

Financing Costs: Interest' principal on debt and dividends

Capital Budgeting: "ro Forma and DCF #aluation


"ro orma inancial statements: Einancial statements forecastin! future yearsG operations

(se pro forma income and balance sheet statements )exclude interest expense* for capital bud!etin!.

>etermine sales pro&ections' variable costs' fixed costs and estimated capital requirements. Use pro orma statements to compute pro*ect cas& lo/s "ro*ect Cas& Flo/s ; F $ro&ect operatin! cash flow $ro&ect capital spendin! $ro&ect additions to net workin! capital

Depreciation
=conomic and future market values are i!nored. 0trai!ht line1 - fixed percenta!e of the asset base. 0ince depreciation has cash flow consequences only because it affects the tax bill' the /a1 depreciation is computed or tax purposes is t&e relevant met&od or capital investment decisions+ 4odi ied (ccelerated Cost !ecover1 S1stem $4(C!S%: 1DA6 ax :eform -ct allows firms to Hfront9loadH depreciation char!es.
4odi ied (C!S "ropert1 Classes Class ,9year 79year @9year Examples =quipment used in research -utos' computers Cost industrial equipment 4odi ied (C!S Depreciation (llo/ances .ear 1 " , 4 7 6 @ A 361ear ,,.,,/ 44.44 14.A" @.41 :61ear "..../ ,"... 1D.". 11.7" 11.7" 7.@6 ;61ear 14."6/ "4.4D 1@.4D 1".4D A.D, A.D, A.D, 4.47

Boo' versus 4ar'et #alue: If an assetGs value when sold )i.e.' salva!e value* exceeds )is lower than* its book value' the difference is treated as a !ain )loss* for tax purposes.

Straig&t 3ine versus (C!S Depreciation


he (nion +ompany purchased a new computer system for its office with an installed cost of 2,.'.... he computer is treated as a 79year property under C-+:0 and is expected to have a salva!e value of zero after six9years. What are the yearly depreciation allowances usin! -+:0 depreciation? usin! strai!ht9line depreciation? 4(C!S Depreciation: .ear 4(C!S "ercentage 4(C!S Depreciation Straig&t6line Depreciation

1 " , 4 7 6

"..../ ,".../ 1D."./ 11.7"/ 11.7"/ 7.@6/

Why mi!ht a firm prefer accelerated depreciation' such as C-+:0 tables' to strai!ht9line depreciation?

(dditions to Net 7or'ing Capital


Iiven #W+ at the be!innin! of the pro&ect )date .*' we will calculate future #W+ in either of two ways.

1.

#W+ will !row at a rate of 8 percent per period.

".

#W+ will equal < percent of salesJrevenues each period.

!ecovering N7C at t&e end o t&e "ro*ect .ear . 1 " .ear . 1 " N7C 27..'... 26..'... 2A..'... N7C 27..'... 2@..'... 26..'... (dditions to N7C (dditions to N7C

,/o 7a1s to Do Capital Budgeting "ro)lems

1+

Item )1 item discounting

0eparately forecast revenues' costs and depreciation and discount each item. +an use different discount rates

5+

7&ole pro*ect discounting >etermine pro&ect cash flows from financial statements a. b. 5peratin! +ash Elow #et +apital 0pendin! i. ii. We will only buy equipment at date .. We will only sell equipment at the end of the pro&ect. If' at the end of the pro&ect' we sell the equipment and the market value is !reater than the book value' we record the after9tax cash flow from the sale.

c.

-dditions to #W+ i. We will always recover #W+ at the end of the pro&ect.

Capital Budgeting "ro)lem Fair/a1s Driving !ange


wo friends are considerin! openin! an indoor drivin! ran!e for !olfers. ?ecause of the popularity of !olf in >allas' they estimate that they could rent ".'... buckets at 2, a bucket in the first year' and that rentals will !row by @7. buckets a year thereafter.

he price will remain at 2, per bucket.

=quipment is 79year -+:0 and is expected to have a salva!e value of 1./ of cost after 6 years.

=xpenditures for balls and buckets are 2,'... initially. balls and buckets will !row at 7/ per year.

he cost of replacin!

#et workin! capital needs are 2,'... to start. 7/ per year.


hereafter' #W+ !rows at

he relevant tax rate is 17 percent. he required rate of return is 17 percent.

=valuate the pro&ect for 6 years. 0hould your friends proceed with the pro&ect?

Fair/a1s Driving !ange


E<uipment !e<uirements Item ?all >ispensin! Cachine ractor and -ccessories ?all $ickup Cachine ,otal Cost $=% "'...... A'...... A'...... 1>?000+00

9perating Costs per .ear Item Land Lease Water =lectricity 0eed 3 Eertilizer Labor )0alaried* Iasoline Caintenance Insurance Ciscellaneous ,otal Cost $=% 1"'...... 1'7..... ,'...... "'...... ,.'...... 1'7..... 1'...... 1'...... 1'...... :3?000+00

Fair/a1s Driving !ange


Step 1: Forecast !evenues: Eorecasted ".'... buckets at 2, a bucket in the first year' and rentals will !row at @7. buckets a year thereafter. he price will remain at 2, per bucket. .ear 1 " , 4 7 6 Step 5: Forecast costs o )alls and )uc'ets: Eorecasted that expenditures for balls and buckets are 2,'... initially. replacin! balls and buckets will !row at 7/ per year. .ear 1 " , 4 7 6 Balls @ Buc'ets ,'...... he cost of Buc'ets 2".'... !evenues 26.'...

Fair/a1s Driving !ange


Step 3: Depreciation: >epreciation of 21A'... of 79year equipment usin! -+:0 .ear 1 " , 4 7 6 otal 0alva!e value of equipment equals 1./ of cost ; 21'A...... pay taxes on this income when the equipment is sold. Step B: "ro orma income statement <ear 1 :evenues %ariable +osts Eixed +osts >epreciation =?I axes #et Income <ear" <ear, <ear 4 <ear 7 <ear 6 he firm will have to (C!SA ".... ,"... 1D.". 11.7" 11.7" 7.@6 Depreciation Boo' #alue

Fair/a1s Driving !ang


Step :: Forecast Increases in Net 7or'ing Capital #et workin! capital needs are 2,'... to start. year. .ear . 1 " , 4 7 6 Step -: Forecast 9perating Cas& Flo/s 0 9perating Cas& Flo/ 2.... hereafter' #W+ !rows by 7/ per

Net 7or'ing Capital ,'......

Increase in N7C

.ear . 1 " , 4 7 6

EBI, 2....

C Depreciation 2....

6 ,axes 2....

Fair/a1s Driving !ange


Step ;: Forecast ,otal Cas& Flo/s

.ear . 1 " , 4 7 6

9perating Cas& Flo/ 2....

6(dditions to 7or'ing Capital 2,'......

6 Capital Spending 21A'......

0 ,otal Cas& Flo/ )2"1'......*

Step >: 7&at is t&e N"# o t&is pro*ect8 .ear . 1 " , 4 7 6 "resent #alue Factor 1... ,otal Cas& Flo/s )2"1'......* "#$Cas& Flo/s% )2"1'......*

Evaluating E<uipment /it& Di erent Economic 3ives


- firm is choosin! between two pieces of equipment under the followin! circumstances

1. ".

he pieces of equipment have different economic lives Whatever piece the firm buys' it needs it indefinitely. -s a result' the piece of equipment will be replaced when it wears out.

Example: - firm is considerin! which of two stampin! machines to buy. Cachine - costs 21.. to buy and 21. per year to operate. It wears out and must be replaced every two years. Cachine ? costs 214. to buy and 2A per year to operate. It lasts for , years and then must be replaced. I!norin! taxes' which machine should the firm buy if the appropriate discount rate is 1./? What is the present value of the cost of Cachine -?

What is the present value of the cost of Cachine ??

Evaluating E<uipment /it& Di erent Economic 3ives Example $continued%


Like the comparison between an A/ interest rate compounded semi9annually and an A."7/ interest rate compounded annually' to compare the costs of the above machines we want to calculate an e<uivalent annual cost+ ,&e e<uivalent annual cost $E(C% is t&e present value o a pro*ectDs costs calculated on an annual )asis+

1 1 - (1 + r)t PV(Costs) = AC r PV(Costs) = AC (Annuity factor)

What is the =-+ for Cachine -? Cachine ??

Which machine should the firm buy?

Evaluating Cost Cutting "roposals


+onsider the decision to up!rade existin! facilities to make them more cost effective. he financial mana!er has to determine whether these cost savin!s are lar!e enou!h to &ustify the necessary capital expenditure. +onsider a pro&ect to automate some part of an existin! production process. a. b. c. d. he necessary equipment costs 2A.'... to buy and install. he pro&ect will save 2""'... per year )pretax* by reducin! labor and material costs. =quipment is 79year -+:0 and is expected to have a salva!e value of 2".'... after 6 years. he tax rate is ,4 percent and the discount rate is 1. percent.

#ote1 here are no workin! capital consequences. 0hould the firm undertake the pro&ect?

Evaluating Cost Cutting "roposals


(se the table below to calculate the pro&ectGs cash flows for each year. Item
=?I >epreciation axes 5peratin! +ash Elow #et +apital 0pendin! otal +ash Elow

<ear .

<ear 1

<ear "

<ear ,

<ear 4

<ear 7

<ear 6

0hould the firm undertake the pro&ect if the discount rate is 1. percent per year? Why or why not?

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