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Original Title: Advanced Capital Budgeting

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3- 2

Overview

Traditional methods for project selection

DCF and the relevant project cash flows

Mutually exclusive investments Projects

with unequal economic life

A formula for the infinite replications NPV

Optimal investment timing with growth

The simple problem (without rotations)

Timing with replications (rotations)

3- 3

Capital rationing and constrained optimization

One-period rationing

Multi-period rationing

Probabilistic constraints (Budget-at-Risk)

3- 4

period and the Internal Rate of Return (IRR) have also been

used. These methods are synopsized below.

1. Payback method: the number of years to recover the cash

outlay. This method ignores a) time-value-of-money

b) cash flows.

2. Internal Rate of Return (IRR): the rate that equates

present value of cash outflows and inflows (accept if IRR is

greater than opportunity cost of capital).

This method does not maximize wealth. It assumes

reinvestment at the same rate, ignores different project

scales, and may lead to multiple IRR solutions.

3- 5

Net Present Value (NPV): accept project if Net Present Value

(of discounted cash flows) is greater than zero.

The only method that allows correct decisions and is

consistent with wealth maximization, considers all cash flows

and preserves the value additivity principle (of present

values).

To calculate NPV cash flows are discounted at the weighted

average cost of capital (WACC).

3- 6

NPV

a) we ignore noncash expenses (depreciation),

b) we ignore interest payments, debt principal repayment, and

interests tax effects, but

c) we include the tax credit from depreciation.

Then we discount cash flows at the appropriate discount rate

(the WACC).

3- 7

Discounting Review

Ct

t

t 1 (1 K )

The present value is a sum of present

values.

3- 8

constant growth perpetuity

growth rate g:

i.e. Ct= (1+g) Ct-1

PV C /( K g )

3- 9

Annuity -

() (annuity)

(PV) =

1

C

t

K K 1 K

3- 10

NPV

NPV and a simple example

If the economic life of a project is 10 years, the investment

capital required is equal to 5000, the company is at a tax

bracket of 50%, is using a 10% discount rate for the cash

flows of the project, and uses straight line depreciation, what

is the NPV of the project?

We will use the pro forma income statement below to

estimate the cash flows.

3- 11

NPV

-------------------------------------------------------------------------Rev revenue

2500

-VC variable costs

-700

-FCCfixed cash costs

-300

- dep noncash (depreciation)

-500

------------EBITearnings before interest and taxes

1000

-kdD interest payments (kd = interest, D = principal)

-100

------------EBT earnings before taxes

900

-T taxes (at c = 50%)

-450

------------NI net income

450

3- 12

NPV

The true cash flows to use are

Thus NPV =

PV(1000 for 10 years discounted at 10% p.a.) 5000 =

6144.57 5000 = 1144.57.

The project has a positive NPV and is thus accepted

3- 13

NPV

Another example

An investment to improve production efficiency requires

capital outlay 10000, it has an economic life of 5 years and

saves annually 3000 in salaries. Investment is financed with a

loan of 15% per year, the principal to be repaid (amortized)

by 10000/5 = 2000 per year. Taxes are at 40% and after tax

cost of capital is 20%.

What is the NPV? (the 5 year annuity factor is 2.991)

3- 14

NPV

Answer

Cash flows are: 3000(1-0.40)+0.40(2000)

=2600 per year.

Present value of cash flows: 2600(2.991)

= 7776.60

NPV = 7776.60 10000 = -2223.40

NOT ACCEPTABLE

3- 15

unequal economic life

We will consider projects with unequal economic lives, under

the assumption that they can be replicated. The following

methods have been used:

economic total life, and then compare NPVs.

2. Find the equivalent annuity value for all, and then

compare.

3. Compare using the NPV with infinite replications

(assuming replication at constant scale).

3- 16

unequal economic life

From the three methods above, only the third (the infinite

replications NPV) is always correct.

If the projects under comparison have the same risk (thus

they have the same relevant discount rate), then the first two

methods are correct too.

3- 17

Say, projects A, B,, have NPV(A), NPV(B), and

economic life T(A), T(B),, and discount rates K(A) and

K(B).

Each has a PVAF(K,T) = present value annuity factor(K,T).

By definition, for all projects

NPV = PVAF(K,T)(equivalent annuity value)

=> (equivalent annuity value) = NPV / PVAF(K,T).

3- 18

Also, the infinite replications (rotations) NPV for a project

with an economic life N (and a relevant discount rate K),

denoted as NPV(N,) equals

and of course

NPV(N,)K = (equivalent annuity value)

The last is another formula to get the equivalent annuity

value assuming that we have calculated the NPV(N,).

3- 19

A formula for the infinite replications NPV.

We often need a formula for the infinite replications

(rotations) NPV(N,). We can easily show from

NPV(N,) = NPV(N) + NPV(N)/(1 + K)N

+ NPV(N)/(1 + K)2N +

that

NPV(N,) = NPV(N) (1 + K)N/[(1 + K)N 1]

3- 20

To show that the above formula holds, simply remember that

the value of every project rotation at the end of its economic

life equals NPV(N) (1 + K)N, since the effective

compounding per period of N years equals (1 + K)N. This is

repeated an infinite amount of times, with a discount rate per

period (of N years) equal to [(1 + K)N 1]. Using the

perpetuity formula it is obvious that the above holds. In case

the project can be replicated n times,

NPV(N,n) = NPV(N) + NPV(N)/(1 + K)N

+ NPV(N)/(1 + K)2N + + NPV(N)/(1 + K)Nn

which with the use of an annuity formula gives

NPV(N,n) = NPV(N) (1 + K)N[1-(1+K)(-nN)]/[(1+K)N 1].

3- 21

Example

We have two mutually exclusive projects with different lives.

Their cash flows are:

Year

Project A

Project B

0

-10.00

-10.00

1

6.00

6.55

2

6.00

6.55

3

6.55

The opportunity cost of capital is 10% for A, but 40% for the

riskier project B. For each project we must calculate the

simple NPV, the NPV(N,), and the annual equivalent value.

Which project should be accepted and why?

3- 22

Example

The simple NPV first:

Year CF(A) PVIF(10%) PV

CF(B) PVIF(40%) PV

0

-10.00

1.000 -10.00 -10.00

1.000

-10.00

1

6.00

.909

5.45 6.55

.714

4.68

2

6.00

.826

4.96 6.55

.510

3.34

3

6.55

.364

2.39

------------.41

.41

3- 23

Example

The NPV(N,) for each project is:

NPV(N,) for A =

.4 1

1 .1 2

1 .1 2 1

. 4 1(1 . 2 1 / . 2 1) . 4 1( 5 . 7 6 1 9 ) 2 . 3 6

NPV(N,) for B =

. 4 1 1 1. 4. 43 1 . 4 1( 2 . 7 4 4 / 1 . 7 4 4 ) . 4 1(1 . 5 7 3 4 ) . 6 5

3

For A: k NPV(N,) = .10(2.36) = .236

For B: k NPV(N,) = .4(.65) = .260

Answer: We accept project A (contributes the greater wealth

if replicated forever at constant scale)

3- 24

GROWTH

The simple problem (without rotations)

Assume that the project cannot be replicated. We seek to

find the optimal timing of a project that maximizes value,

given growth on the underlying revenues (and/or the costs).

This problem is often called the optimal harvesting or optimal

tree-cutting problem in economics. Note that the revenues

Rev(t) are a function of time. Often and especially in new

sectors, new products, etc., the more we wait, the higher the

(future) value of investing. But there is an opportunity cost in

the sense that we defer the arrival of revenues (heavier

discounting). Thus, we have a trade-off.

3- 25

GROWTH

The more general problem would involve two capital costs.

Cost I is paid at time zero in order to buy the lot, plant, etc.,

and cost X is paid at harvest time (say the cost of harvesting).

The cost X(t) could in general also be a function of time, but

capital I is paid up front and is treated as a sunk cost. We

assume a continuous discount rate equal to K for both the

revenues and the costs of harvesting. So we maximize the net

revenues after having incurred cost I:

Max(t) [Rev(t) e-Kt - X(t) e-Kt - I] = Max(t) [(Rev(t) - X(t)) e-Kt]

3- 26

GROWTH

In order to find the optimal timing that would maximize

investment value, we set the derivative in respect to time

equal to zero:

0 = - K e-Kt (Rev(t) - X(t)) + e-Kt [dRev(t)/dt - dX(t)/dt]

and after removing e-Kt and solving for K we get the important

result

K = [dRev(t)/dt]/Rev(t) when X(t) = 0,

or in the more general case

K = [dRev(t)/dt - dX(t)/dt]/(Rev(t) - X(t)).

Note: you must remember how to calculate derivatives

3- 27

GROWTH

This result says that the maximum value is when the marginal

rate of return by holding the tree lot equals the opportunity

cost of capital K. Obviously in any realistic example this rate

of return is eventually decreasing, so beyond this point it is

not beneficial to hold the tree lot and we should harvest. By

taking the derivative of the revenue function in respect to

time and solving for time, we find the optimal investment

timing.

Then, we still need to find the NPV of such an investment.

Having found the optimal timing does not guarantee that

NPV would necessarily be positive.

3- 28

Example

The concepts will be further demonstrated with an example.

At time t = 0 we invest capital cost I = 15000 in a tree lot. When

we harvest we get revenues Rev(t) = 10000sqrt(1+t). There is

an opportunity cost of capital K = 5% with continuous

discounting. In this example the expenses in order to harvest

are zero (constant in time and X = 0).

K = [dRev(t)/dt - dX(t)/dt]/(Rev(t) - X(t)), so

K = [dRev(t)/dt]/Rev(t).

3- 29

Example

K = [dRev(t)/dt]/Rev(t).

= [(0.5)10000/sqrt(1+t)]/[10000sqrt(1+t)]

= 1/[2(1+t)]

and since K = 0.05

and optimal t = 9 years.

3- 30

Example

the NPV. Finding the optimal timing is not enough.

For t = 9, net present value:

(10000sqrt(1+9))exp(-0.05(9)) 15000

= 31622.78(0.637628) 15000 = 20163.57 15000

= 5163.57

It is positive and we accept the project.

3- 31

Example - discussion

pay I = 15000 (an option price). This gives us the option to

the optimal timing of the investment on an underlying asset

valued at time zero at Rev(t=0) = 10000sqrt(1+t) = 10000.

Rev(t) is the underlying asset of this investment option (net

of any exercise costs).

This simple (investment) option involves no uncertainty, it is

simply a timing option.

3- 32

(discrete discounting)

We will see another example, that we will solve iteratively

(no equation solution). This will demonstrate that optimal

solution is when g = K. Note that here we have two growth

rates, one for the revenues and one for the capital cost, so that

the aggregate growth rate differs (is a function of time).

There is an investment with two years life, capital cost I =

10000 and net (after tax) revenues equal to 6000 per year (for

two years). The discrete cost of capital is K = 10%. If the

investment decision is deferred, the revenues grow at a

discrete growth rate of 5% per year, and the capital cost to

invest I grows at a discrete growth rate of 4.75%.

3- 33

Visual Example

If for example we invest now, NPV equals 413.2231. If we

wait for a year, the capital cost I = 10475, and the yearly

revenues equal 6300 per year. The NPV one year later would

be equal to 458.8843, exhibiting a growth rate of 11.05%.

The present value of that investment today equals 417.1675.

Looking at the numerical results for timing of the investment

up to 10 years later, it is obvious that we maximize NPV if

we wait for about 4 years. At that time, the growth rate of

waiting equals 10.1234 that is close to the 10% cost of

capital.

The analytical calculations follow:

3- 34

Visual Example

Value at T

NPV

413.2231

413.2231

---------

458.8843

417.1675

0.1105

508.016

419.8479

0.107068

560.8482

421.3736

0.103997

617.625

421.8462

0.101234

678.6056

421.3607

0.098734

744.0648

420.0052

0.096461

814.2947

417.8619

0.094387

889.6048

415.0072

0.092485

970.3237

411.512

0.090736

10

1056.8

407.4421

0.089121

3- 35

Visual Example

Note that if there was a single growth rate (the same growth

rate for net revenues and the capital cost), if g > K we should

wait for ever (!!!), if g < K we must make the investment

immediately (should have been made already), and if g =

K we are indifferent about the timing.

These are of course not realistic examples, aggregate g for the

project value in general should not be constant. The visual

example instead is very realistic since .

3- 36

GROWTH & ROTATIONS

Assume a project can be replicated many times (rotations).

We need an initial capital I in order to start the process (to

own the rights to this investment). Every time we harvest,

we get net revenues equal to (Rev(t) - X(t) ). This allows us

to get to the next harvest, and so on. We face the

optimization problem

Max(t)[NPV(t) =

I+(Rev(t) X(t))e-Kt +(Rev(t) X(t))e-2Kt +(Rev(t) X(t))e-3Kt

= I+PV(t)]

where PV(t) equals the present value of the net revenues for all

rotations.

3- 37

GROWTH & ROTATIONS

For N rotations we have (easy to prove)

PV(t) = [Rev(t) X(t)](1 e-KNt)/[(1 e-Kt) eKt]

and for infinite rotations (N ) we get

PV(t) = [Rev(t) X(t)]/(eKt 1).

So finally for infinite rotations we get the NPV(t) equal to

NPV(t) = I + (Rev(t) X(t))/(eKt 1).

Note: not optimal t yet.

3- 38

GROWTH & ROTATIONS

To optimize this function we set the first derivative equal to

zero (note that I is not a function of time):

0

= dNPV(t)/dt = 0 + dPV(t)/dt = d[(Rev(t) X(t))/(eKt 1)]/dt

= [d(Rev(t) X(t))/dt]/(eKt 1)] + (Rev(t) X(t))d(eKt 1)-1/dt

= [d(Rev(t) X(t))/dt]/(eKt 1)]

+ (Rev(t) X(t))(1)KeKt /(eKt 1)2

= [d(Rev(t) X(t))/dt] + (Rev(t) X(t))(1)KeKt /(eKt 1)

=>

d[Rev(t) X(t)]/dt = [Rev(t) X(t)]K/(1 e-Kt)

or

K = (1 e-Kt) {d[Rev(t) X(t)]/dt}/[Rev(t) X(t)]

3- 39

(not optimal t yet)

Call the discount factor e-Kt = U and rewrite

NPV(t) + I = (Rev(t) X(t))U + (Rev(t) X(t))U2 +

+ (Rev(t) X(t))UN

and multiply both sides by U

(NPV(t) + I)U = (Rev(t) X(t))U2 + (Rev(t) X(t))U3 +

+ (Rev(t) X(t))UN+1

and subtract the first from the second to get

(NPV(t) + I)(U 1) = (Rev(t) X(t))UN+1 (Rev(t) X(t))U

and for N->: (NPV(t) + I)(U 1) = 0 (Rev(t) X(t))U

so NPV(t) = I (Rev(t) X(t))U/(U 1)

= I + (Rev(t) X(t))/(eKt 1)

3- 40

Numerical Example

We use X(t) = X = 15000, K = 0.05 and

Rev(t) = 10000sqrt(1+t),

we use d[Rev(t) X(t)]/dt = [Rev(t) X(t)]K/(1 e-Kt)

we get

d[Rev(t) X(t)]/dt = d[Rev(t)]/dt = 10000d[sqrt(1+t)]/dt

= 10000(0.5)/[sqrt(1+t)]

and [Rev(t) X(t)]K/(1 e-Kt)

= [10000sqrt(1+t)-15000](0.05)/(1 e-0.05t)

which due to the non-linearity is solved by approximation

(numerically-with trial and error) to give (approximately)

t = 4.6. The NPV must also be calculated depending on I to

decide if the project is finally accepted or not.

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