Capital Project Evaluation

• Overview and “vocabulary”

• Methods
– Payback, discounted payback
– NPV
– IRR
– Sensitivity Analysis
– Breakeven Analysis
 ?What is Project Appraisal

• Analysis of potential projects.

• Long-term decisions; involve large
expenditures.
• Very important to firm’s future.
 Steps in Project Appraisal
• Estimate cash flows (inflows & outflows).
• Determine r = WACC for project.
• Evaluate cash flows.
 Cash Flow Estimation Of Project

Initial Terminal
outlay Cash flow

0 1 2 3 4 5 6 ... n

Annual Cash Flows

 Cash Flows Versus Profit
• Cash flow is not the same thing as profit, at
least, for two reasons:
– First, profit, as measured by an accountant, is
based on accrual concept.
– Second, for computing profit, expenditures are
arbitrarily divided into revenue and capital
expenditures.

CF  (REV  EXP  DEP)  DEP  CAPEX

CF  Profit  DEP  CAPEX

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 Components of Cash Flows
• Initial Investment
• Net Cash Flows/Annual Cash Flows
– Revenues and Expenses
– Depreciation and Taxes
– Change in Net Working Capital
– Change in accounts receivable  
– Change in inventory  
– Change in accounts payable  
– Change in Capital Expenditure
– Free Cash Flows

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 Components of Cash Flows

• Terminal Cash Flows

– Salvage Value
– Salvage value of the new asset
– Salvage value of the existing asset now
– Salvage value of the existing asset at the end of its
normal
– Tax effect of salvage value  
– Release of Net Working Capital

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Terminal Value for a New Business
• The terminal value included the salvage value of the asset
and the release of the working capital.
• Managers make assumption of horizon period because
detailed calculations for a long period become quite
intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after the
horizon period without involving detailed calculations.
• A simple method of estimating the terminal value at the end
of the horizon period is to employ the following formula,
which is a variation of the dividend—growth model:

NCFn  1  g  NCFn 1
TVn  
kg kg
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 Additional Aspects of Cash Flow
Analysis
• Opportunity Costs of Resources
• Sunk Costs
• Tax Incentives
– Investment allowance    
– Other tax incentives  

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 Cost of Capital

• The project’s cost of capital is the

minimum required rate of return on funds
committed to the project, which depends
on the riskiness of its cash flows.
• The firm’s cost of capital will be the
overall, or average, required rate of return
on the aggregate of investment projects.

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The Concept of the Opportunity Cost
of Capital
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
OCC

. Equity shares

. . Preference shares

. . Corporate bonds

Government bonds
Risk-free security

Risk

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 The Weighted Average Cost of Capital
• The following steps are involved for calculating
the firm’s WACC:
– Calculate the cost of specific sources of funds
– Multiply the cost of each source by its proportion in
the capital structure.
– Add the weighted component costs to get the WACC.

WACC is in fact the weighted marginal cost of capital

(WMCC); that is, the weighted average cost of new
capital given the firm’s target capital structure.
 Cost of Equity Capital

• Cost of Equity: The Dividend—Growth

DIV1
Model ke  g
P0
 Cost of Debt
• Debt Issued at Par
INT
kd  i 
B0

• Tax adjustment  
After-tax cost of debt  kd (1  T )
 WACC
• Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from
capital)+ (Cost of debt x Proportion of debt
from capital)+
 ?What is the payback period

The number of years required to

recover a project’s cost,

or how long does it take to get the

business’s money back?
 Payback for Franchise L
(Long: Most CFs in out years)
0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

 Franchise S (Short: CFs come
quickly)
0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

NPV: Sum of the PVs of inflows and
outflows.
n
CFt
NPV   .
t  0 1  r 
t

Cost often is CF0 and is negative.

n
CFt
NPV    CF0 .
t 1 1  r 
t
 ?What’s Franchise L’s NPV
Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Rationale for the NPV Method

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
 Using NPV method, which
?franchise(s) should be accepted

If Franchise S and L are mutually •

exclusive, accept S because NPVs >
. NPVL
If S & L are independent, accept •
.both; NPV > 0
 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
NPV: Enter r, solve for NPV.
n
CFt

t  0 1  r 
t
 NPV .

IRR: Enter NPV = 0, solve for IRR.

n CFt
  0.
t  0 1  IRR
t
 ?What’s Franchise L’s IRR
0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
 Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
 Normal Cash Flow
:Project
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power plant, strip mine.
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN