Capital Budgeting

Contents

 Capital Budgeting-role in financial management

 Techniques for Capital Budgeting

 NPV

 NPV - An Example

 Uncertainty & Capital Budgeting

 Sensitivity Analysis

 Scenario Analysis

 Monte Carlo Simulation

 Breakeven Analysis

 Decision Tree

 Real Options

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 What is capital budgeting?

 Capital budgeting is the DECISION MAKING process that companies use for
allocating funds across a range of capital projects – projects with a life of a
year or more.

 - comprise the long-term assets on the balance sheet

 - could be fairly large in relation to existing b/s footing (make or break)

 - cannot be reversed at a low cost

 - require sound decision making rationale / techniques

 . Quality of decision making matters: accouting vs. economic based approaches to analysis

 - techniques of analysis are similar to security analysis and valuation

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 Classification of capital projects

 1- Replacement prjects

 2- Expansion projects

 3- New products and services

 4- Regulatory, safety and environmental projects

 5- Others (R&D; Special Interest)

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 The capital budgeting process

 1- Generating ideas

 2- Analyzing individual proposals

 3- Planning the capital budget

 4- Monitoring and post-audit: systematic errors, variances, feedback

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 The capital budgeting terminology

 Sunk cost: cost already incurred.

 Opportunity cost: what a resource is worth in its next best use.

 . What is the investment outlay for an idle property? What is the op cost of replacing an old machine
with a new machine? What is opportunity cost of an owner’s time given to a business?

 Incremental cashflow: cflow with a decision minus the cflow without a …

 Externality: effects on other parts of the firm, environment or society; the

benefit or harm of an inv decision to other things besides inv

 Conventional versus nonconventional casflows: cashflows can flip b/e +ve

and –ve!

 Independent versus mutually exclusive

 Project sequencing

 Capital rationing
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 Opportunity cost: example

 You are asked to prepare a feasibility report for opening a new branch of
your bank on a piece of land that the bank already owns. The land was
purchased @ $50,000/- some five years ago. It has since been vacant and
not employed for any purpose. When evaluating the prospective branch,
should the cost of the land be disregarded because no additional cash
outlay would be required? Should the purchase price be taken as
opportunity cost? How about market price of the land (150,000)?

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  The answer is that there is an opportunity cost inherent in the use of the
property. In this case, the land could be sold to yield $150,000 after taxes.
Use of the site for the branch would require forgoing this inflow, so the
$150,000 must be charged as an opportunity cost against the project. Note
that the proper land cost in this example is the $150,000 market-determined
value, irrespective of whether the company originally paid $50,000 or
$500,000 for the property. (What the company paid would, of course, have an
effect on taxes, hence on the after-tax opportunity cost.)

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 Capital Budgeting? A Summary
 Financial Questions
 What investments to make?
 How to finance them?

 Types Investments
 Physical Assets
 Financial Assets
 Intangible Assets

 Capital budgeting provides the answer to investments in physical assets

 It is a process of planning & managing a firm’s long term investments

 Identify assets that are worth more to the firm than their cost
 Value of cash flows generated by the asset exceeds the cost of that asset

 How Capital Budgeting helps?

 How much cash is expected?-Size
 When is the cash expected?-Timing
 How likely is that the cash is received?-Risk

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 Techniques for Capital Budgeting
 Net Present Value (NPV): pv of future after-tax c/f minus the inv outlay

 Internal Rate of Return (IRR): the discount rate that makes pv of future after tax c/f
equal to investment outlay.

 Payback Period: THE NUMBER OF YEARS REQUIRED TO RECOVER THE ORIGINAL

INV.

 Discounted Payback Period: number of years required to equate cumulative

discounted cashflows from a project with original investment

 Accounting Rate of Return: Average net income /average book value

 Profitability Index: PV of future cfs / initial inv OR 1 + NPV / Initial investment

NPV leads to better investment decisions than other criteria

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 How to use NPV?
Wish to assess the an investment

 Forecast the cash flows over the economic life

 Determine the opportunity cost of capital

 Time value money
 Risk

 Discount the future cash flows

 Add the discounted cash flows to calculate present value

 Calculate NPV by subtracting investment from PV

FCF1 ____
____ FCF2 FCF
____ PVH
____
PV = + + …… +
H
+
1
(1+R) (1+R) 2 (1+R)H (1+R)H
NPV = -C0 +PV

If NVP > 0, invest, if NPV < 0 don’t invest

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 Measuring Cash Flows

Free Cash Flow (FCF) = EBIT (1-Tax Rate) - Additions to WCR +Dep - Capex

Sales Additions in WCR Depreciation

- Cost of Goods Sold = WCRYR 2- WCR YR 1  Straight Line

= Gross Margin  Modified Accelerated

Cost Recovery
- Depreciation

- ASE Capex
WCR
= EBIT  Capital Expenditure
during the economic
Account Receivables
- Taxes life of assets
+ Inventory
=EBIT X (1-Tax Rate)
- Accounts Payables

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 Measuring Cost of Capital
WACC = E/ (D+E) RE + D/(D+E)RD(1-Tax Rate)

Equity Debt

 Market Value of Equity  Market value of debt

 Price per share X  Price of a Bond X No of

Outstanding shares Bonds

After Tax Cost of Debt RE = Rf+ ß(Rm-Rf)

 RD is the return demanded Rf = Risk Free Rate

by creditors
ß = Beta
 YTM in the market
(Rm= Market Rate
 RD(1-Tax Rate)

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 5. CASH FLOW PROJECTIONS
The goal is to estimate the incremental cash flows of the firm for each year in the
project’s useful life.
0 1 2 3 4 5
| | | | | |
| | | | | |

Investment After-Tax After-Tax After-Tax After-Tax After-Tax

Outlay Operating Operating Operating Operating Operating
Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow
+
Terminal
Nonoperating
Cash Flow

= Total After- = Total After- = Total After- = Total After- = Total After- = Total After-
Tax Cash Tax Cash Tax Cash Tax Cash Tax Cash Tax Cash
Flow Flow Flow Flow Flow Flow

Copyright © 2013 CFA Institute 14

 INVESTMENT OUTLAY

Start with Capital expenditure

Add Increase in working
capital
Equals Initial outlay

Copyright © 2013 CFA Institute 15

 AFTER-TAX OPERATING CASH FLOW
Start with Sales
Subtract Cash operating expenses
Subtract Depreciation
Equals Operating income before taxes
Subtract Taxes on operating income
Equals Operating income after taxes
Plus Depreciation
Equals After-tax operating cash flow

Copyright © 2013 CFA Institute 16

 TERMINAL YEAR AFTER-TAX
NONOPERATING CASH FLOW

Start with After-tax salvage value

Add Return of net working capital

Equals Nonoperating cash flow

Copyright © 2013 CFA Institute 17

 FORMULA APPROACH
Initial outlay Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0) (6)

After-tax operating CF = (S – C – D)(1 – T) + D (7)

cash flow
CF = (S – C)(1 – T) + TD (8)

Terminal year after-tax TNOCF = SalT + NWCInv – T(SalT – BT) (9)

nonoperating cash flow
(TNOCF)

FCINV = Investment in new fixed capital S= Sales

NWCInv = Investment in working capital C= Cash operating expenses
Sal0 = Cash proceeds D= Depreciation
B0 = Book value of capital T= Tax rate

Copyright © 2013 CFA Institute 18

 Example: expansion

 Assume a firm is interested in developing an additional fast

food outlet. It will cost $2 mn to acquire and develop the site,
including erection of buildings; of this sum, $400,000
represents plant and equipment depreciable for tax purposes
on a s.l. basis for 5 years. Additionally, net investment in
working capital would be to the tune of 10% of annual sales.
Sales are expected to be $600,000 in the first year and to grow
to $700,000 in the second and subsequent years. Direct cost
of labour and materials in goods sold average about 40% of
this sales level. Other costs (e.g. salaries, training,
advertising, etc.) are budgeted to cost $150,000 annually. The
store is expected to be sold by the end of third year at 20%
higher than its original cost. Mgmt’s estimate is that sales in
another established outlet that they own will decline about
10% during the first year of the new project. This second
outlet generates annual sales of $700,000. Find out if it is
financially feasible for the firm to invest in the second outlet.

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 Year 0 Year 1 Year 2 Year 3
Operating Cashflows
Sales
Less: Cost of Sales
Gross Profit
Less: Operating Costs
Depreciation
Net profit before tax
Less tax
Net profit after tax
Add back depreciation
Operating Cashflow after tax

Other cashflows

initial development costs

Proceeds of sale
Incremental working capital
Recovery of working capital
Net cashflow, pre tax
Net cashflow, after tax
IRR
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 Year 0 Year 1 Year 2 Year 3
Operating Cashflows
Sales 530,000 700,000 700,000
Less: Cost of Sales 212,000 280,000 280,000
Gross Profit 318,000 420,000 420,000
Less: Operating Costs 150,000 150,000 150,000
Depreciation 80,000 80,000 80,000
Net profit before tax 88,000 190,000 190,000
Less tax 0.47 41,360 89,300 89,300
Net profit after tax 46,640 100,700 100,700
Add back depreciation 80,000 80,000 80,000
Operating Cashflow after tax 126,640 180,700 180,700
Other cashflows
initial development costs (2,000,000)
Proceeds of sale 2,400,000
Incremental working capital (53,000) (17,000)
Recovery of working capital 70,000
Net cashflow, pre tax (2,053,000) 151,000 270,000 2,740,000
Net cashflow, after tax (2,053,000) 109,640 180,700 2,650,700
IRR 13%
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 Example

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 Solution

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 Risk Analysis

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 Uni t pri ce 5
Annual uni t sal es 35,000
Vari abl e cost per uni t 1.5
Tax rate 40%
Requi red rate of return 12%
Year 0 1 2 3 4 5 6
Investment outlay: -
Fi xed capi tal 300,000
NWC 50,000
Total 350,000

Annual after tax operating cashflows

Sal es 175,000 175,000 175,000 175,000 175,000 175,000
Operati ng expenses 52,500 52,500 52,500 52,500 52,500 52,500
Depreci ati on 50,000 50,000 50,000 50,000 50,000 50,000
EBIT 72,500 72,500 72,500 72,500 72,500 72,500
Taxes on operati ng i ncome 29,000 29,000 29,000 29,000 29,000 29,000
Op i ncome after taxes 43,500 43,500 43,500 43,500 43,500 43,500
add back dep 50,000 50,000 50,000 50,000 50,000 50,000
after tax Op cashfl ow 93,500 93,500 93,500 93,500 93,500 93,500

Termi nal year after-tax non-operati ng cashfl ows

sal vage val ue 60,000
NWCI 50,000
Tax 24,000
Total 86,000
Total after tax cashfl ow (350,000) 93,500 93,500 93,500 93,500 93,500 179,500
NPV (350,000) 83,482 74,538 66,551 59,421 53,054 90,940
77,987

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 Sensitivity Analysis

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Capital Budgeting & Uncertainty
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 Scenario Analysis

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 Example: Sensitivity Analysis
• ABC is considering a project with the following
cashflows. Measure the sensitivity of the
project to changes in variables:
Year 0 1 2
Initial Outlay (7,000)
Sales 6,500 6,500
Var costs (2,000) (2,000)
Net cashflows (7,000) 4,500 4,500
RADR 8% unit price $10
Year 0 1 2 PV
Initial Outlay (7,000) (7,000)
Sales 6,500 6,500 11,591
Var costs (2,000) (2,000) (3,567)
Net cashflows (7,000) 4,500 4,500 8,025
RADR 8%
PV (7,000) 4,167 3,858
NPV 1,025
Sensitivity to:
Initial Outlay 14.6%
Sales volume 12.77%
Selling Price 8.84%
Var costs -28.73%
Break-even analysis
Output lev el and total costs
Accounting break-even costs
 Sunlight Manufacturing Company-A Example

Wants to make a decision to enter the desk lamp market

 Marketing Department (Rupees in Hundreds )
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
 Market Estimates New Equipment -1,000,000
Unit Price 50 48 46 44 40 40
 Mfg Department Unit Sales per year 30000 35000 40000 42000 44100 46305

 Equipment cost Sales 1,500,000 1,680,000 1,840,000 1,848,000 1,764,000 1,852,200

C ost of Goods Sold 750,000 840,000 920,000 924,000 882,000 926,100
 Inventory Selling & General 150,000 168,000 184,000 184,800 176,400 185,220
Depreciation Rate 20% 32% 19.20% 11.52% 11.52% 5.76%
 Labor cost
Depreciation -200,000 -320,000 -192,000 -115,200 -115,200 -57,600
 Material cost EBIT 400,000 352,000 544,000 624,000 590,400 683,280
Tax Rate 40% 40% 40% 40% 40% 40%
 Finance Department EBIT(1-Tax Rate) 240,000 211,200 326,400 374,400 354,240 409,968
Inventory 125,000 131,250 137,813 144,703 151,938 159,535 167,512
 A/P & A/R estimates A/R 250,000 262,500 275,625 289,406 303,877 319,070 335,024

 WACC is 12% A/P -62,500 -65,625 -68,906 -72,352 -75,969 -79,768 -83,756
WC R 312,500 328,125 344,531 361,758 379,846 398,838 418,780
 Tax Rate 40 percent C hanges in WC R -312,500 -15,625 -16,406 -17,227 -18,088 -18,992 -19,942
Recovery of WC R 418,780
C apex 200,000 320,000 192,000 115,200 115,200 57,600
Free C ash Flows 208,750 178,388 291,947 338,224 316,255 788,864
PV 1,017,958
NPV 17,958

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 Uncertainty

 That is excellent but does it represent reality?

 How comfortable is the Finance Manager with cash flow?

 In real world, we face uncertainty

 Uncertainty is more things can happen than will happen

 Capital Budgeting decision and uncertainty

 When confronted with a cash flow forecast try to discover what else can happen?

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 Sensitivity Analysis
Sensitivity analysis is the investigation of what happens to NPV when
only one variable is changed
Otabi Corporation is considering investing in Electric Scooters

Yens in Billion
Year 0 Year 1-10  Marketing Department
Investments 15  100,000 scooters
Revenue 37.5  10% Share
Variable Cost 30  Unit cost is 375 K
Fixed Cost 3
Depreciation (St.line) 1.5  Production Department
EBIT 3  Variable Cost per unit is 300 K
Tax (50%) 1.5  Fixed cost is 3 Million
EBIT(1-T) 1.5
EBIT(1-T)+Dep 3  NPV depends upon 5
Change in WCR 0 0 Variables
Capex 0 0  Market size
FCF -15 3  Market share
WACC 10%  Unit price
NPV 3.43  Unit variable cost
 Fixed cost

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 Sensitivity Analysis
RANGE
Variable Pessimistic Expected Optimistic
Benefits
Market Size 0.9 M 1M 1.1 M
 Provides information about
Market Share 4% 10% 16% where forecasting errors will
Unit Price ¥350,000 ¥ 375,000 ¥ 380,000 do the most damage

Unit Variable Cost ¥ 360,000 ¥ 300,000 ¥ 275,000  additional information and

Fixed Cost ¥4B ¥ 3B ¥ 2B
worry of various departments

NPV (¥ in Billions)
Problems with Sensitivity Analysis
Variable Pessimistic Expected Optimistic
Market Size 1.1 3.4 5.7  What is optimistic, and What is
pessimistic?
Market Share -10.4 3.4 17.3
Unit Price 5.0 3.4 5.0  Does not consider inter-
Unit Variable Cost -15.0 3.4 11.1 relationship between the
variables
Fixed Cost 0.4 3.4 6.5

Case adopted from Principles of Corporate Finance by Brealey & Myers

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 Scenario Analysis
NPV analysis under conditions when an entire set of variables is
assigned values based on different states in future
Scenarios (¥ in Billions) Cash Flows (Years 1-10 ¥Billions)
Variable Base High Oil Base High Oil Prices
Case Prices & Case & Recession
Recession Revenue 37.5 44.9
Market Size 1.1 3.4
Variable Cost 30.0 35.9
Market Share -10.4 3.4 Fixed Cost 3.0 3.5
Unit Price 5.0 3.4 Dep 1.5 1.5
Unit Variable -15.0 3.4 EBIT 3.0 4.0
Cost
EBIT (1-Tax 1.5 2.0
Fixed Cost 0.4 3.4 Rate)
FCF 3.0 3.5
PV 18.4
Benefits Investment 15.0
NPV 3.4
 Considers the inter-
relationship between different
variables Problems with Scenario Analysis

 Allows to analysis of  There can be a large number of

consistent combinations scenarios

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 Break Even Analysis
Break even analysis is used to determine the number of units at which
the NPV is zero
Methodology

 Calculate cash flows for different units of sales

 Calculate PV of both cash inflows & outflows

 Use graphical or algebraic methods to

calculate units at which NPV=0 (in ¥ Billions)

Inflows Outflows
Year 1-10 Year 0 Year 1-10
Units Revenues Inv Variable Fixed Taxes PV PV NPV
Sales Costs Costs Inflows Outflows
0 0 15 0 3 -2.25 0 -19.6 -19.6

100000 37.5 15 30 3 1.5 230.4 227.0 3.4

200000 75.0 15 60 3 5.25 460.8 434.4 26.4

WACC=10% ,Tax Rate = 50%

Assume Changes in WCR=0

Straight Line Depreciation over 10 year, No Salvage Value of Assets

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 Break Even Analysis
Break Even Analysis What Does it tells us?

 All things being equal, 85 K units

380 PV Inflows
PV Outflows
must be sold
PV, Billions of yen

280  Helps appreciate Op leverage

 Improve technology reducing
180 NPV=0 variable cost but increasing fixed
No of Unit 85000 costs increases NPV to ¥9.6 Billion
 Variable cost reduces to ¥ 120 K &
80
Fixed cost increases to ¥19 Billion
 Result Break Even sales increases
-20 to 88,000 units
0 100000 200000
Number of Units  A new sensitivity analysis indicate a
high level of sensitivity to market
share & unit price
 Which technology to use-
recalculate NPV using higher
discount rate

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 Break Even Analysis
Accounting Break Even Analysis
Accounting vs. DCF Break Even
80 Revenues
Analysis
Accounting Revenues & Costs

70 Costs
 Better technique than
60 Accounting Break even analysis
50
40  Opportunity cost of capital
Break Even
30 No of Unit 65000  Accounting analysis does not take it into
account
20  ¥1 Billion yen at 10 year annuity at 10%
10 per year can earn ¥2.44 billion

0
 Lockheed Managers & Tri Star
0 100000 200000 Case
Number of Units

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