WARNING

This collection of slides provides an idea of the course

structure and key words.

It is NOT intended to substitute the readings required

by the instructor.

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 TCH321
CORPORATE FINANCE
Nguyen Manh Hiep
2020

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 CHAPTER 3
CAPITAL BUDGETING
Nguyen Manh Hiep

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 In this chapter:

I.
• COMMON METHODS

II.
• COMMON INDICATORS

IV
• REAL OPTIONS

V
• HOMEWORK
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 I. COMMON METHODS
What is Capital Budgeting
 The process used for decision making on projects
with life >=1 year.
 With the goal to maximize shareholder value.
 Very important for the future of a company.
 Spanning from generating investment ideas, to
information gathering, planning and analyzing,
monitoring and post-auditing.

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 I. COMMON METHODS
Categories of Investment Projects
 Replacement projects.
 Expansion projects.
 New product/market development projects.
 Mandatory projects.
 Other projects (R&D…).

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 I. COMMON METHODS
Projects may be
 Independent.
 Mutually Exclusive.
 Dependent/Sequencing.

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 I. COMMON METHODS
Principles of Capital Budgeting
 Valuation is based on cash flows.
 Cash flows are forecasted based on
opportunity costs.
 Financing costs are most often reflected in
discount rates, not cash flows.

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 I. COMMON METHODS
Three Common Methods
 Weighted Average Cost of Capital (WACC).
 Adjusted Present Value (APV).
 Flow-to-Equity.
 The examples in this chapter are based on the
following assumptions:
a) The project has average risk.
b) The firm’s D/E ratio remains constant.
c) Corporate taxes are the only imperfections.
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 I. COMMON METHODS
WACC Method
 Estimate project’s free cash flows.
 Calculate WACC.
 Accept/Reject the project based on NPV.
Note: Some people call this “Free-cash-flow method”.

FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv

= EBIT(1-t) + NCC – FCInv – WCInv

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 I. COMMON METHODS
WACC Method
 Estimate project’s free cash flows: a collaborative
art of multiple departments in the firms.
 Calculate WACC:
o Cost of equity: historical stock returns, CAPM,
DDM, Cost of debt plus risk premium…
o Cost of debt: cost of incremental debt used for
the project.
 Calculate NPV and other indicators: easy.
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 I. COMMON METHODS
Adjusted present value (APV) Method
 APV = NPV + PV (Financing side effects)
 NPV is the investment’s value without the effects
of leverage.
 Financing side effects: interest tax shield, costs of
issuing new securities, costs of financial distress...
 Requires more information than WACC method.

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 I. COMMON METHODS
APV
 Initially, tax shield is discounted using the cost of
debt.
 Myers (1974), Interactions of Corporate Financing and Investment Decisions
– Implications for Capital Budgeting, Journal of Finance Vol. 29.
 Later research suggests that tax shield should be
discounted at weighted average cost of capital
(this version of APV is called Capital Cash Flow
Approach).
 Booth (2002), Finding Value Where None Exists: Pitfalls in Using Adjusted
Present Value, Journal of Applied Corporate Finance Vol. 15.
 I. COMMON METHODS
Flow-to-Equity Method
 Calculate FCFE.
 Estimate cost of equity.
 Discount FCFE the cost of equity to calculate value
to shareholders.
 Requires more information than WACC.

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 I. COMMON METHODS
Sunk Costs
 In 2008 R&D department expected to develop a
muscle-improving drug in 2 years at a cost of $1
million. Present value of the benefits from the
project is $2 million. The project failed.
 In 2010 R&D department did the same project with
the same expectations. The project failed again.
 Now it is 2012. R&D department expects to
develop that muscle-improving drug within 2 years
at a cost of $1 million. Present value of the benefits
from the project is $2 million. Should the company
carry out the project again? 15
 I. COMMON METHODS

Working Capital
 Required working capital increases when firms
proceed additional projects.
 When projects end, working capital is recovered.

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 I. COMMON METHODS
Fixed Assets
 The choice of different depreciation methods does
not affect free cash flows directly.
 The effects of different depreciation methods are
through the deferral of tax expenses.
 At terminal year, salvage value of fixed assets and
its effect on taxes must be included in the
calculation of cash flows.

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 II. COMMON INDICATORS
NPV

IRR

PI

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 II. COMMON INDICATORS

NPV vs IRR
Example: Mai Linh Company
Project 0 1 2 3
Small -10 6 6 6
Big -50 25 25 25

 Cost of capital: 12%.

 Draw NPV profiles (20%, 23.4%, 36.3%).
 Comment on IRR (YTM) of these two projects.
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 II. COMMON INDICATORS
NPV vs IRR
Example: Mai Linh Inc. wants to replace an existing packing
printer with a new high-speed printer.
The old machine was bought 10 years ago at $15 mn,
depreciated using straight-line method in 15 years (current
book value $5 mn), current market value $2 mn.
New machine $24 mn, economic life 5 years, depreciated using
double declining method. New machine will reduce $6 mn costs
of labor and materials each year. At the end of year 5 new
machine can be sold at $4 mn.
Tax rate 30%. Cost of debt 12%. Risk free rate 5%. Beta 0.9.
Market risk premium 15%. Debt-to-equity 1:2.
Evaluate the project. 20
 II. COMMON INDICATORS
NPV vs IRR
Example: Mai Linh Inc. wants to set up a new plant for use in 4 years.
Buy new buiding and equipment $40 mn. Fixed assets are completely
depreciated during an economic life of 10 years using double-
declining method. At the end of year 4, expected market value of
building and equipment are $15 mn.
Estimated sales from the new plant $80 mn at year 1, growing by 10%
annually. Variable cost 60% of sales, fixed cost (excluding
depreciation) $10mn. Working capital requirements $8 mn at time 0,
and 10% of the increase in sales thereafter. All WCInv fully recovered
after 4 years. Tax rate 30%. Cost of debt 12%. Risk free rate 5%. Beta
1.2. Market return 15%. Debt-to-equity 2:1. Evaluate the project.
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 II. COMMON INDICATORS
NPV
When two projects are mutually exclusive with
different lives, assume that they can be replaced
indefinitely as they wear out, 2 procedures to make
decisions:
 Least common multiple of lives approach.
 Equivalent annual annuity approach.

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 II. COMMON INDICATORS
NPV
 Photox Company is considering 2 projects with the
same cost of capital 12%.
 ML Photocopy Machine.
Year 0 1 2 3 4 5 6
-20 bil 4 bil 7 bil 6.5 bil 6 bil 5.5 bil 5 bil
 TB Photocopy Machine.
Year 0 1 2 3
-10 bil 3.5 bil 6.5 bil 6 bil
 Calculate NPV, IRR? 23
 II. COMMON INDICATORS
Ex: Tuan Bach Company projects
NPV
Project 0 1 2 PI
@10%
A -20 30 30 32 2.6
B -10 30 5 21 3.1
C -5 15 10 17 4.4
 If Tuan Bach has VND20 billion.
 VND25 or 30 billion and can (can not) invest in
a portion of the projects.
 VND10 billion and can postpone the project
until next year. 24
 II. COMMON INDICATORS
Popularity of Indicators
 US and Canada: 75% always use NPV, 76% always use
IRR. 57% use PB, but mostly as a secondary tool.
 Graham & Harvey (2001), The Theory and Practice of Corporate Finance:
Evidence from the field, Journal of Financial Economics
 Survey of 313 European firms. NPV and PB are 42%-50%,
44%-51%, 47%-69%, respectively.
 Brounen et. al. (2004), Corporate Finance in Europe: Confronting Theory
with Practice, Financial Management 33.
 Asian firms: NPV and PB are 88% and 95%.
 Kester et. al. (1999), Capital Budgeting Practices in the Asia-Pacific region:
Australia, Hong Kong, Indonesia, Malaysia, Philippines, and Singapore,
Financial Practice and Education 9.
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 III. Risk analysis

Risk Analysis
 Sensitivity analysis
 Scenario analyisis
 Monte Carlo simulation

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 III. Risk analysis

Risk Analysis: An Example in Slide 30.

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 IV. REAL OPTIONS
Types of Real Options
 Timing options.
 Abandonment options.
 Expansion options.
 Flexibility options.
 Fundamental options.

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 IV. REAL OPTIONS
How to Deal with Real Options?
 Ignore the options.
 Adjusted NVP = NPV (without options) + Value of
options.
 Use decision trees.

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 IV. REAL OPTIONS
Example: Mai Linh Inc. wants to set up a new plant to produce a muscle-improving
dietary supplements. Project life is in 5 years. Buy new buiding and equipment $50 mn.
Fixed assets are completely depreciated during an economic life of 10 years using
double-declining method. At the end of year 5, expected market value of P&E are $15
mn. Variable costs 30% of sales. Fixed costs excluding depreciation is $20mn. Sales
will increase 10% each year.
Working capital requirements at time 0 are 10% of the first year’s revenue, and 10% of
the increase in sales thereafter. All WCInv fully recovered after 5 years. Tax rate 30%.
Cost of debt 12%. Risk free rate 5%. Beta 1.2. Market return 15%. Debt-to-equity 2:1.
a. Mai Linh forecasted that there is a 50% probability that sales will be $50mn (good
case) and a 50% probability that sales will be $30mn (bad case) in the first year.
Evaluate the project.
b. Whether good case or bad case will materialize will be known after the first year.
After the first year, Mai Linh has the option to abandon the project. Abandonment will
result in liquidation of fixed assets for 30 million, and recollection of WCInv at the end
of year 1. Evaluate the project. Calculate the value of the abandonment option.
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 V. HOMEWORK
Investment Decision and CEO Turnover
(optional)
 Read Weisbach1995 and explain why investment
changes when CEO is changed.

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 V. HOMEWORK
Intrafirm resource allocation and investment
(optional)
 Read Harris1996 and explain how intrafirm
resource allocation for investments can be
inefficient.

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End of Chapter 3

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