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Capital Budgeting

Should we build this plant?

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Agenda

What is Capital Budget? What are Cash Flow Streams? What type? How do I Estimate Cash Flow? Principles?

Cash Flow Illustration Cash Flow for Replacement Project Basis in Cash flow Estimations

How do I apprise / Decide ?

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What is capital budgeting?

Analysis of potential additions to fixed assets.

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Importance

Long-term decisions; involve large outlay / expenditures. Very important to firms future value. Difficult to undo/ Irreversible

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What are the Stages of Capital Budgeting?


Capital budgeting is a six-stage process: 1. Identification stage 4. Selection stage 2. Search stage 5. Financing stage

3. Information-acquisition stage
6. Implementation and control stage
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Steps to capital budgeting


1. 2. 3. 4. 5.

Estimate CFs (inflows & outflows). Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR. Accept if NPV > 0 and/or IRR > WACC.

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What is the difference between independent and mutually exclusive projects?

Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other. (Launch of New Bike by Bajaj)
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What Capital Budgeting Decision Do your propose / take?

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Typical CB Decisions Types


Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research and Development Projects Miscellaneous Projects
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What is the difference between normal and nonnormal cash flow streams?

Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non normal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project.

E.g. Nuclear power plant, strip mine, etc.

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Cash Flow Estimates and Elements


Initial Investments (FA + WC) Operative Expenses Terminal Cash Flow (SV + WC)

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Initial Investment

Cost of the new assets + Net working capital Required for the new asset

After tax salvage value realised from the old asset + Net working capital required For the old asset

Operating cash inflows =

Operating cash inflows From the new asset

Operating cash inflows From the old asset, had it Not been replaced After tax salvage value of The old asset, had it Not been replaced + Recovery of net working Capital associated with The old asset
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Terminal cash flow

Cash Flow Estimate:

Replacement Project

After tax salvage value Of the new asset + Recovery of net working Capital associated with The net asset

For how long would you estimate cash Flows ?

Time Horizon For Analysis


Physical Plant Life Technological Life of Asset/Facility Product Market life of the Plant Investment Planning Horizon of the firm

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How do I Estimate Cash Flows?

Separation Principle

Financing and Investment Activity

Post Tax Principle


Tax Rate (Marginal v/s Average or effective) Treatment of Losses Effect of Non Cash Charges on Cash Flow and Tax Depreciation
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Treatment of Losses for Tax Purpose


Scenario
1

Project
Incurs Losses

Firm
Incurs Losses

Action
Defer Tax Savings

2
3

4
Stand alone

Incurs Losses Makes Profits Makes Profits Incurs Losses

Makes Profits Incurs Losses Makes Profits -

Take Tax Savings in the year of loss Defer Taxes until the firm makes profits Consider Taxes in the year of Profit Defer tax savings until the project makes profits10-15

Cash Flow Estimation

Consistency Principle

Investor group

All Investor or Equity holders Cash Flows is computed accordingly Cost of Capital

Inflation Nominal Cash Flow Real cash Flow

Nominal Dscnt rate Real Discount Rate


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How do I estimate cash flows?

Incremental Principle

Product Cannibalization (New Press in Ujjain served earlier by Indore) Ignore Sunk Cost (Cost Committed Irrecoverably, Old Press facility at Ujjain) Opportunity Cost (if had rented the facility or facility can be sold or cost of replacing resource required elsewhere for the project etc.) Overhead Allocation (e.g General Admn exp, managerial salaries, legal expenses, rent etc HO cost to be now shared by new project as well) Working Capital Estimate
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0
Fixed Net WC (CA-CL) Revenue Cost Depreciati on Tax

1.

N (Last)

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Work Sheet: Expansion Project Cash Flows


S.No 1 Capital equipment 2 Level of working capital (ending) 3 Revenues 4 Raw material cost 5 Labout Cost 6 Operating and maintenance cost 7 Loss of contribution 8 Depreciation 9 Bad debt loss 10 Profit before tax 11 Tax 12 Profit after tax Net salvage value of capital 13 equipment 14 Recovery of working capital 15 Initial investment 16 Operating cash inflow (12+8+9) 17 Working capital 18 Terminal cash flow (13+14) 19 Net cash flow (15+16-17+18) 0 1 2 3 Rs in million 4 5

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Work Sheet: Project Cash Flows S.No 1 Fixed assets 2 Net working capital 3 Revenues Costs (other than 4 depreciation and interest) 5 Depreciation 6 Profit before tax 7 Tax 8 Profit after tax Net salvage value of fixed 9 assets Recovery of net working 10 capital 11 Initial outlay 12 Operating cash flow (8 + 5) 13 Terminal cash flow (9 +10) 14 Net cash flow (11+12+13) Book value of investment 0 1 2 Rs in million 3 4 5

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MiniCase

(text page 338)

Estimate the cash flows from two different points of view


Cash Flows from the point of all investors Cash flows from the point of equity investors

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Work Sheet: Project Cash Flows S.No 1 Fixed assets 2 Net working capital 3 Revenues Costs (other than depreciation 4 and interest) 5 Loss of Rental 6 Depreciation 7 Profit before tax 8 Tax 9 Profit after tax 10 Net salvage value of fixed assets 11 12 13 14 15 Recovery of net working capital Initial outlay Operating cash flow (8 + 5) Terminal cash flow (9 +10) Net cash flow (11+12+13) 0 -15 -8 1 2 Rs in million 3 4 5

30

30

30

30 20 1 1.582 7.418 2.2254 5.1926

30 20 1 1.187 7.813 2.3439 5.4691 5 8

20 20 20 1 1 1 3.75 2.813 2.109 5.25 6.187 6.891 1.575 1.8561 2.0673 3.675 4.3309 4.8237

-23 8.925 10.518 11.7147 12.6106 13.282 13 8.925 10.518 11.7147 12.6106 26.282

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Work Sheet: Cash Flows for the Replacement Project S.No I. Investment Outlay 1 Cost of new asset 2 Salvage value of old asset 3 Increase in net working capital 4 Total net investment(1-2+3) II. Operating Inflows 5 After-tax savings in manufacturing costs 6 Depreciation on new machine 7 Depreciation on old machine 8 Incremental depreciation(6-7) 9 Tax savings on Incremental depreciation(0.4x8) 10 Net operating cash inflow(5+9) III. Terminal cash inflow 11 Net terminal value of new machine 12 Net terminal value of old machine 13 Recovery of incremental net working capital 14 Total terminal cash inflow(11-12+13) IV. Net Cash Flow (4+10+14) 0 1 2 3 Rs in million 4 T

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Techniques of Capital Budgeting

DISCOUNTED CASH FLOW (DCF)


NON DISCOUNTED CASH FLOW


NPV IRR MIRR BCR NBCR Disc PBP

PBP ARR

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What is the payback period?

The number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

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Calculating payback
Project L
CFt Cumulative
0
-100 -100

1
10 -90

2
60 -30

2.4
100 0

80
50

PaybackL
Project S CFt Cumulative PaybackS

= 2 =
0 -100 -100

+
1

30 / 80 1.6
2

= 2.375 years
3 20 40

70 -30

100 50 0 20

= 1 =

30 / 50

= 1.6 years
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Strengths and weaknesses of payback

Strengths

Provides an indication of a projects risk and liquidity. Easy to calculate and understand. Ignores the time value of money. Ignores CFs occurring after the payback period.
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Weaknesses

Discounted payback period

Uses discounted cash flows rather than raw CFs.


0
10%

1 10 9.09 -90.91

2 60 49.59 -41.32

2.7 3
80 60.11 18.79 = 2.7 years
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CFt PV of CFt Cumulative

-100 -100 -100 2 +

Disc PaybackL = =

41.32 / 60.11

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:

CFt NPV t t 0 ( 1 k )
n

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What is Project Ls NPV?


Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9.09 49.59 60.11 $18.79

NPVS = $19.98
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Solving for NPV: Financial calculator solution

Enter CFs into the calculators CFLO register.


CF0 CF1 CF2 CF3

= = = =

-100 10 60 80

Enter I/YR = 10, press NPV button to get NPVL = $18.78.


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Rationale for the NPV method


NPV = PV of Inflows PV of Outflows = PV of Benefits PV of Cost = Net gain in wealth

If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

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Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

CFt 0 ( 1 IRR ) t t 0
n

Solving for IRR with a financial calculator:


Enter CFs in CFLO register. Press IRR; IRRL = 18.13% and IRRS = 23.56%.
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How is a projects IRR similar to a bonds YTM?


They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the bond project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20.

Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
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Rationale for the IRR method

If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

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IRR Acceptance Criteria


If IRR > k, accept project. If IRR < k, reject project.

If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL.
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NPV Profiles

A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5
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Drawing NPV profiles


NPV 60 ($)
50

. 40 .
30 20

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

10
0 5 -10

. .
15

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)


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Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive

If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.
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Finding the crossover point


1. 2.

3. 4.

Find cash flow differences between the projects for each year. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. Can subtract S from L or vice versa, but better to have first CF negative. If profiles dont cross, one project dominates the other.
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Reasons why NPV profiles cross

Size (scale) differences the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects. Timing differences the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
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Reinvestment rate assumptions


NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
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Since managers prefer the IRR to the NPV method, is there a better IRR measure?

Yes, MIRR is the discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. MIRR assumes cash flows are reinvested at the WACC.
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3 Steps in MIRR Calculation


1.

Estimate PV of Cost (Cash outflow) of Project (PVC)


PVC = PV Cash Outflow

2.

Estimate Terminal Value (Future Value) of Project Cash Inflow


TV = PV Cash Inflow

3.

Obtain MIRR by Solving


PVC = TV / (1+MIRR)n
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Calculating MIRR
0 -100.0
10%

1 10.0
10% MIRR = 16.5%

2 60.0
10%

3 80.0 66.0 12.1 158.1


TV inflows

-100.0
PV outflows

$100 =

$158.1 (1 + MIRRL)3

MIRRL = 16.5%
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Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.
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Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project Ps NPV and IRR.
0 -800
k = 10%

1 5,000

2 -5,000

Enter CFs into calculator CFLO register. Enter I/YR = 10. NPV = -$386.78. IRR = ERROR Why?
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Multiple IRRs
NPV

NPV Profile
IRR2 = 400%

450 0 100 IRR1 = 25%


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400

-800

Why are there multiple IRRs?

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.
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Solving the multiple IRR problem

Using a calculator

Enter CFs as before. Store a guess for the IRR (try 10%) 10 STO IRR = 25% (the lower IRR) Now guess a larger IRR (try 200%) 200 STO IRR = 400% (the higher IRR) When there are nonnormal CFs and more than one IRR, use the MIRR.
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When to use the MIRR instead of the IRR? Accept Project P?

When there are nonnormal CFs and more than one IRR, use MIRR.

PV of outflows @ 10% = -$4,932.2314. TV of inflows @ 10% = $5,500. MIRR = 5.6%.

Do not accept Project P.

NPV = -$386.78 < 0. MIRR = 5.6% < k = 10%.


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