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Original Title: Capital Budgeting Basics

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Capital Budgeting Basics

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10-1

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

10-2

10-3

Importance

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

10-4

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

10-5

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.

10-6

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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10-8

Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research and Development Projects Miscellaneous Projects

10-9

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.

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

10-11

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 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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Replacement Project

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

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

10-13

Separation Principle

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

10-14

Scenario

1

Project

Incurs Losses

Firm

Incurs Losses

Action

Defer Tax Savings

2

3

4

Stand alone

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

Consistency Principle

Investor group

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

10-16

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

10-17

0

Fixed Net WC (CA-CL) Revenue Cost Depreciati on Tax

1.

N (Last)

10-18

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

10-19

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

10-20

MiniCase

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

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

-23

10-22

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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PBP ARR

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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

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

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

10-28

Disc PaybackL = =

41.32 / 60.11

CFt NPV t t 0 ( 1 k )

n

10-29

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

10-30

= = = =

-100 10 60 80

10-31

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.

10-32

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

Enter CFs in CFLO register. Press IRR; IRRL = 18.13% and IRRS = 23.56%.

10-33

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

10-36

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

10-37

NPV 60 ($)

50

. 40 .

30 20

. .

.

L

10

IRRL = 18.1%

10

0 5 -10

. .

15

20

. .

.

23.6

10-38

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.

10-39

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.

10-40

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.

10-41

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.

10-42

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.

10-43

1.

PVC = PV Cash Outflow

2.

TV = PV Cash Inflow

3.

PVC = TV / (1+MIRR)n

10-44

Calculating MIRR

0 -100.0

10%

1 10.0

10% MIRR = 16.5%

2 60.0

10%

TV inflows

-100.0

PV outflows

$100 =

$158.1 (1 + MIRRL)3

MIRRL = 16.5%

10-45

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.

10-46

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?

10-47

Multiple IRRs

NPV

NPV Profile

IRR2 = 400%

10-48

400

-800

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.

10-49

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.

10-50

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

10-51

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