Capital Budgeting Process Budgeting Process Capital Budgeting Process

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Chapter 9

CAPITAL BUDGETI NG
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PROCE SS

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1. INTRODUCTION # Working with the left-hand-side of a balance sheet

# CAPITAL BUDGETING /INVESTING in Long-term Assets ! Definitions " " Capital: Fixed assets used in production Budget: Plan of in- and outflows during some period

" Capital Budget: A list of planned investment (i.e., expenditures on fixed assets) outlays for different projects. " Capital Budgeting: Process of selecting viable investment projects.

" Financial investment vs. economic investment ! In this course, investments are needed in order to: " " Expand in existing markets. Replace existing capital assets.
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" Enter new markets.

Capital Budgeting Process !

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Where do these projects come from? " Suggested by managers of plants & divisions " Upper management

Upper management approves these projects

! !

Investment and financing decisions are independent. Some common errors: " Expansion without incorporating cost of financing " Cost cutting without looking at revenue side " Ignoring alternative uses of capital CAN BE USED IN: M&As Divestitures & spin-offs Correct-sizing Other
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# TOOLS

! ! ! !

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# CAPITAL BUDGETING OUTLINE

Develop tools & criteria of selecting projects (Ch. 8): Given Q Relevant CFs Q The required return of the project (i.e., the risk of use of project CFs) Determine which CFs are relevant in project analysis (Ch. 10) Introduce possibility of forecast error in CF data used in analysis (Chapter 11) Assume that k (cost of financing) is known until Ch. 12

! ! !

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Capital Budgeting Process Choose Appropriate

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Financing

F I NA N C I A L M A N A G E M E N T Choose Appropriate PROCESS Working capital

Given your Type of Business Line of Business List Potential Projects Type of Projects Internal External Divestitures Expansion (M&A) & Spin Offs Choose Viable Projects Optimal ? Dividend polic
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Capital Budgeting

Capital Structure Short-term financial Management Dividend Policy

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CAPITAL BUDGETING & FINANCING

INVESTMENT DECISION

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MANAGERIAL TALENT & IN VESTMENTS

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2. TOOLS OF INVESTMENT DESIRABILITY 2.1 BASIC INTUITION 1)Criteria How fast you re-coup initial investment? Benefits > Costs Compare PV of cash inflows & PV of cash expenditure Compare return on investment & cost of financing project 2)A word of Caution A manager needs to make a decision today (t=0) given estimated/forecasted cash flows. Obviously there is no guarantee that the decision would always turn out as anticipated. However, what is important is that the manager has to make the best decision at t=0 given all the relevant information. 2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS: # Independent: A project that has nothing to do with other projects under investigation. Example: # Replace copy machine and build a new plant. Mutually Exclusive: You only need one of these alternative projects. Example: Buy IBM or Apple PC?
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2.3 TOOLS 3.1 Payback Period Method:

Criterion: For two mutually exclusive projects, choose the one that pays you back your initial cost the sooner.

Example: Calculating Payback Period Given the following CFs, and k = 10%, we get: Investment Initial cost CF1 A B $10,000 10,000 0 $10,000 CF2 $14,400 2,400

choose project B, since it pays back initial investment in one year.

? Is this choice optimal?

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3.2 Net Present Value (NPV) method:

L Payback

ignores the concept of CFs. Ignores CF after payback and risk of CFs.

we need to look at the PV of these CFs net of any initial cost. NPV ' PV of all Relevent CFs & Initial Investment where, 1 / Net cash flow (inflow - outflow)nat time t CF CF2 CF CFt % / Initial cost or investment...% % outlays cost of capital (financing)k)n I0 (1%k)1 / (1%k)2 (1% / required return reflecting risk of use of k CFs n CFt 'j
n

CFt

Note: CF0 / I0 ' j (1

t'0

& I0

t'1

(1%k)t

%k)t
k,1 ]

' CF 1 [PVIF

% CF

[PVIF

k,2 ]

% ... % CF

[PVIF

k,n ]

&I

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Thus, NPV measures the additional market value that management expects the project to create (or destroy) if it is undertaken.

NPV Criteria:
Since the objective of the manager is to maximize value, then for

Independent Projects : Choose All Projects with NPV > 0. Mutually Exclusive: Choose projects with the highest NPV.

Note:

NPV > 0 is equivalent to PV of cash inflow > PV of cash outflow.

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Example: Calculating NPV

Given the following CFs, and k = 10%, we get:

Investment Initial cost CF1 A B Solution: $10,000 10,000 0 $10,000

CF2 $14,400 2,400

$14,400 & 10,000 ' $1,901 2 NP VA ' (1%k) 10,000 2,400 %_______________&10,000 ' $1,074 NPVB ' (1 %.1)1 (1 %.1)2

choose A, since it has the highest NPV if mutually exclusive, or both if independent as they are both with NPV >0.

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Remarks on payback method:

With payback method, project B is selected. Thus, if you ignore amount, timing, and risk of CFs, then potentially you would end up with the wrong valuation. Both projects would add value to shareholders. However, if you select project "B", you would not be maximizing shareholder value, as "A" provides more value to shareholders. In general, if you accept a project with NPV <0, then you are destroying shareholder value!

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Value created perProcess ' Capital Budgeting share

Example: Calculating additional Shareholder Value

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Using a project's NPV = $1,901 and assuming that there are 1,000 shares outstanding, then

NPV # of shares outstanding

$1,901 '________ ' $1.901 1,000 If the project is adopted then the price of the stock should increase by $1.90.

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3.3 Internal Rate of Return Method (IRR)

#

Motivation: ! Internal in that it is a rate of return that depends on the CFs of the project. ! Return on investment (ROI) is a very intuitively appealing concept; measured in % terms.
ROI ' profit investment

Easy to determine profit if you have single CF in future. What about if we have multi-period payoffs?

Periods 0 CF from project -100 10 1 2 60 80 3

Profit would be calculated as: Ending Value - Beginning Value = $80 - $100 But this calculation ignores the intermediate CFs, namely $10 and $60 in periods 1 and 2 respectively.

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Thus, when examining the return on a project, we need a new tool that would incorporate all the cash flows of a project.

Definition of IRR : IRR is defined as that particular k, such that the project breaks-even, i.e., when NPV = 0. Thus,

% CF 2 % ...% CF N Decision Rule: % CF 1 NPV' 0 ' CF 0 2 (1 % IRR) (1 % IRR) (1 % IRR) N

IRR Criterion: Choose projects with IRR higher than cost of financing.

If [the cost of financing "k"] < IRR NPV > 0 Additional value would be created. Obviously the larger the difference between k & IRR, the higher the NPV. Note: Use IRR cautiously for mutually exclusive projects! Limitations of IRR are discussed on p. 21.

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Example: Calculating IRR (single future CF)

Given: Period 0 1 Solution: 300 &100% ________________ ' 0 (1 %IRR) 300____ ' 100 (1 %IRR) 100(1%IRR ) ' 300 100 % 100IRR ' 300 300&100
IRR '____________ '

CF($) -100 300

200
' 2 ' 200%

100 The ROI is:

100

ROI ' $300 & $100 ' 200% $100

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Example: Calculating IRR (multiple future CFs) Given: Periods 0 CF from project F -100 IRRF = ? 1 10 2 60 3 80

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Capital Budgeting Process

Try a smaller #, say IRR =

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Solution: calculate IRR (just like YTM) there is no simple formula to use. Thus, we need to use either trial & error method or a calculator. From definition of IRR, ______________CF ____________1 CF 2 CF N % CF 0 %___________ %__________ % '0 (1%IRR) (1%IRR) 2 (1 %IRR) N
...

L To

Guess an IRR, say IRR = 19%, then substituting in above equation yields:

10 60 80 <0 &100%________ %__________ %_________ (1%.19)3 (1%.19) (1%.19)2

You have guessed a number too high. 17%, thus

10 60 80 &100%___________ %__________ %_________ (1%.17) (1%.17)2 (1%.17)3

If you try IRR = 18.1%, you get correct answer. IRRF = 18.1 % (using either trial & error or calculator)

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NPV Flow Profile: Relation between NPV, IRR, and "k"

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Problems With IRR for Mutually Exclusive Projects: Problem 1: Consider two projects such that returnA = 15%, returnB = 50%, and k = 10%. Which would you choose?

Now assume that they require the following initial investments: IA = $1,000,000 while IB = $100 ? Which would you choose?

If initial investments are not equal, IRR ranking can be misleading.

Problem 2: Possible existence of multiple IRRs. Every time the CFs change sign, you would get an additional IRR. (See NPV, IRR, "k" profile)

Problem 3:

Possible conflict of ranking with NPV.

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3.4 What tools does industry use?

% use of each Return AROR ' Accounting Rate of Tool accounting profit Primary jmethod NPV after taxt /N IRR (initial outlays % salvage value)/2 payback
t'1

AROR Secondary method where t is time, and N = # of periods NPV

Source: Kim, Crick, and Kim, "Do executives Practice What Academics Preach?" Management Accounting (November 1986), pp. 49-52. payback

IRR

AROR 21% 49 19 8 24% 15 35 19

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So Why Does Industry Still use IRR Despite Problems?

percentage results are more intuitive than a $NPV; 50% return vs. NPV = $500,000 Since IRR gives you break-even cost of financing: The number itself is of interest to managers; you want simply to ask at what financing cost does project break-even? If a project's break-even is 100%, in a "normal" situation, you wouldn't need to go through the trouble of estimating all the CFs, as 100% is considerably higher than a normal financing rate.

? Why Do Managers Use Payback with All of its

Problems?

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3. SUMMARY

T Payback Period T NPV

# # # Independent Projects Mutually exclusive NPV = sum of discounted CFs, where the discount rate is the cost of financing the project.

NPV criterion is equivalent to PV of cash inflow > PV of cash outflow

T IRR
# Criterion Two equivalent ways to look at it Break-even or ROI > cost of financing project # Calculation ! Trial & error ! Calculator

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4. QUESTIONS I.True/Disagree-Explain
1. 2. 3. 4. 5. According to the NPV criterion, you should choose all projects with NPV > 0. According to the IRR criterion, you should choose projects with IRR < cost of financing. Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction. Capital budgeting tools can be used to analyze the merits of "flextime." A NPV > 0 project might not be undertaken because of its high risk, despite the manager's confidence in the accuracy of the CF estimates. If a company is expanding, then it is necessarily creating additional value to shareholders. If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor's profits would be zero.

6. 7.

II.Problems
1) Given: Project S Cost Annual Benefits # of years k $10,000 $4,000 5 14% Project L 25,000 8,000 5 14%

Which of these mutually exclusive projects is better based on NPV and IRR?

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ANSWERS TO QUESTIONS I. Agree/Disagree-Explain

1. Disagree. Only if the projects are independent. If they are mutually exclusive, then you choose the one with the highest NPV. Disagree. If IRR < cost of financing, then the project would be losing money as it costs more to finance than to break-even. Such a project will have NPV < 0. Agree. NPV = -market price + PV of dividends. Present value of a stock would be its Agree worth--value. If you pay (market price) exactly its worth (PV of dividends), then NPV = 0. Agree. Analyzing flextime corresponds to analyzing its impact on a firm's CFs. However, in practice it is difficult to obtain good estimates of the incremental CFs. Thus, if "flextime" makes sense, then you would be undertaking a NPV > 0 project. Disagree. The risk of CFs is reflected in the cost of capital (k). Thus, the fact that you obtain a NPV > 0, and assuming you did the correct calculation, the project should be accepted. Disagree. Only if it is re-investing revenue at a rate higher than the required rate of return. A simple example would be a company borrowing to finance projects that are not profitable, NPV <0. Thus, expansion does not necessarily translate into shareholder value creation. Disagree. NPV = 0 implies that an investor is being compensated by an amount commensurate with the risk and value of the investment, i.e. there are no excess profits.

2.

3.

4.

5.

6.

7.

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II. Problems 1) Step 1 Step 2

Are CFs of equal length? Yes Calculate NPV NPV S = -10,000 + 4 , 000 ( PVIFA 1 4 % , 5 ) = 3,732 NPV L = -25,000 + 8 , 000 ( PVIFA 1 4 % , 5 ) = 2,465

Using IRR: IRR S = 28.6% and IRR L = 18% Since cost of capital for each = 14% < IRR. Accept S as it has a higher IRR. Obviously, you should choose both if they were independent.

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Capital Budgeting Process ELIMINATIONS

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a. APPROACHES TO CAPITAL BUDGETING Top Down Approach Bottom up Approach INTER-DEPENDENCE OF INVESTMENT & FINANCING DECISIONS Illustration 1: Project 1: ATT owes you $100, and makes you an offer of $100 today or $107 next year. Which would you choose? Assume that return on similar risky investments is 6%. Project 2: Suppose, in addition to the ATT opportunity, you have a "great deal" that requires a $100 investment that is expected to payoff $300 in a year. Case 1: Assume: you can borrow at a cost of 10%. Action: Take both projects (independent)

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PVA T T

'

Capital Budgeting Process $107 ' 100.94 > $100 (1 % .06) ' & 100 % 100.94 ' $.94

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NPVA T T

choose $107 as 1.06 ' &1 0 0 % 3 0 0 '

$

PVATT NPV

1727

Thus, if you borrow, in effect you would be undertaking both projects. Total
NPV independent

= NPV ATT + NPV great deal = 0.94 + 172.7 = 173.64

Case 2: You cannot borrow, or cost of borrowing is 400% and assume that a project with same risk as "great deal" has a return of 12%. Action: Mutually exclusive projects

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NPV "great deal "

'

&100 %

300
PV I R S

' &100 % 60 ' &40 <

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Obviously, in this case you are better off taking $100 from ATT. Thus, Choose project with highest NPV choose "great deal".
1% .12 NPV' & 100 %

Notes: !

You discount at 12%, since it is the return you have to forego if you invest in a project with same risk as ATT. NPVindependent > NPVmutually exclusive

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(RR) (EPS1) (ROE) where ROE 'k ROE Capital Budgeting Process .

(( ( )

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b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV p0 = PV (CF of existing business) + NPV ( dividend growth due to investment of future earnings)
PS1 1 % NPVGO k Let RR' Retention Ratio D1 ' (1& RR) (EPS1) return on retained earnings ' (RR) (EPS1) (ROE) EPS1 book equity per share

NPV1 '
& (RR)

& I0 % PV P

of increases CFs

(EPS1) % %
%

(RR) (EPS1)& 1

NPV1, NPV2 ,.... are growing at a rate (RR) (ROE) ' g ______________NPV 1 NPVGO ' k& g EPS1 NPV1 D1 p0 '________ %__________ '_________ k k& g k& g

Substitute NPVGO in (*), we get Conclusions: NPVGO depends on a. EPS1: current earnings size

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0.Relative magnitudes of ROE and k; see equation (**) above. a.Growth, (RR)(ROE), does not necessarily imply NPV .

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c. WHERE DO NPV> 0 PROJECTS COME FROM? # # In long-run NPV = 0 excess economic profit = 0 Sources of NPV > 0 (Sources of competitive advantage) ! Barriers to entry product differentiation economies of scale better distribution channels luck INVESTMENT UNDER UNCERTAINTY Classical micro-economic theory

Observations: # Firms use cost of capital "hurdle rate" in NPV > 3 times cost of capital firms invest only if price is substantially > LRAC (Summers '87) # .# Firms stay in business even after p < AVC First quarter of '85 $ started By end of '87, $ was at '78 level. But, import volume did not until 2 years later. (Krugman & Baldwin '87)

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U.S. firms abandon project earlier than Japanese (TV, VCR, semiconductors)

Explanation: Agree NPV = NPV + flexibility option Sources of option value: # sunk costs in abandonment decision ! Severance pay for workers (-) ! scarp value (+) (Myers & Majd '85) " capital used is industry specific (eg. steel mills) Who is going to buy machinery when entire industry is suffering?! " lemon problem " stop and re-start needs additional costs (McDonald & Siegel '85) # Uncertainty: product price, operating costs, interest rates value in option to wait (Pindyck '91, Ross & Ingersoll '92) ! parameters: " if uncertainly is high value of waiting " if k is low future outcomes valued more value of . option to wait and resolve future uncertainty " What happens if there are other firms in industry? "balance" between waiting and implementing (Fudenburg & Tirole '83, Stiglitz '89) " if k does not Investment as cost of waiting " Why did U.S. abandon color TVs, VCRs and semiconductors? The value of waiting to invest is governed by downside risk. But Japanese government supports

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firms during downside through cartelization to avoid destructive competition. (Bernake '83) !
# Remarks

Sequential investing , as in drug industry If 400% (in above illustration) is the cost of borrowing, maybe that is the Agree cost of financing. If a project sounds "too good to be Agree," it probably is "too good to be Agree." Role of market in information processing vs. personal borrowing market.

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