Ch10 Basics of Capital Budgeting

8/20/2019 Ch10 Basics of Capital Budgeting

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Chapter 10

The Basics of Capital

Budgeting


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Project’s Cash Flows(CFt)

Mar(etinterest rates

!ro-ect.s business ris(

Mar(etris( aversion

!ro-ect.sdebt/e*uity capacity

Project’s risk-adjustedcost of capital

(r)

The Big Picture:The Net Present alue of a

Project

NP ! " " ### "−

$nitial cost

CF

%

CF

&CFN(% " r )% (% " r)N(% " r)&


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hat is capital budgeting 3nalysis of potential pro-ects4 5ong6ter, decisions7 involve large

e'penditures4 "ery i,portant to &r,.s future4


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9teps in Capital Budgeting +sti,ate cash :ows ;in:ows <

out:ows=4 3ssess ris( of cash :ows4 >eter,ine r ? 3CC for pro-ect4 +valuate cash :ows4


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Capital Budgeting !ro-ect

Categories14 $eplace,ent to continue pro&table

operations

24 $eplace,ent to reduce costsA4 +'pansion of e'isting products or ,ar(ets

4 +'pansion into new products/,ar(ets

84 Contraction decisions

@4 9afety and/or environ,ental pro-ects4 Mergers

4 Other


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#ndependent versus

Mutually +'clusive !ro-ects !ro-ects areD

independent% if the cash :ows of one

are unaEected by the acceptance ofthe other4

,utually e'clusive% if the cash :owsof one can be adversely i,pacted by

the acceptance of the other4


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Cash Flows for Franchises

5 and 9

10 8060

0 1 2 310%

L’s CFs:-100.00

70 2050

0 1 2 3

10%S’s CFs:

-100.00


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G

!"D 9u, of the !"s of 3ll

Cash Flows

Cost often is CF0 and is negative4

!" ? H

t ?0

CFt

;1 Ir=t

!" ? H

t ? 1

CFt

;1 I r=tJ CF0


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10

hat.s Franchise 5.s !"

10 8060

0 1 2 310%

L’s CFs:-100.00

9.09

49.59

60.11

18.79 = NPVL NPVS = $19.98.


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11

Calculator 9olutionD +nter"alues in CF5O $egister for56100

10

@0

0

10

CF0

CF1

!"

CF2

CFA

#/K$ ? 14 ? !"5


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$ationale for the !"

Method !" ? !" in:ows J Cost

This is net gain in wealth% so acceptpro-ect if !" L 04

Choose between ,utually e'clusivepro-ects on basis of higher positive!"4 3dds ,ost value4


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)sing !" ,ethod% which

franchise;s= should be accepted #f Franchises 9 and 5 are

,utually e'clusive% accept 9

because !"s L !"54 #f 9 < 5 are independent%

accept both7 !" L 04

!" is dependent on cost ofcapital4


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#nternal $ate of $eturnD

#$$

0 1 2 3

CF0 CF1 CF2 CF3Cost Info!s

#$$ is the discount rate that forces!" in:ows ? cost4 This is thesa,e

as forcing !" ? 04


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18

!"D +nter r% 9olve for

!"

? !" H

t ? 0

CFt

;1 Ir=t


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#$$D +nter !" ? 0% 9olve

for #$$

? 0 H

t ?0

CFt

;1 I #$$=t

#$$ is an esti,ate of the pro-ect.srate of return% so it is co,parableto the KTM on a bond4


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hat.s Franchise 5.s #$$

10 8060

0 1 2 3I"" = #

-100.00

PV3

PV2

PV1

0 = NPV +nter CFs in CF5O% thenpress #$$D #$$5 ? 141A4

#$$9 ? 2A48@4


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0 00

0 1 2 A

6100

Or% with CF5O% enter CFs and press#$$ ? G404

A 6100 0 0

G40

#/K$ !" !MT F"

#!)T9

O)T!)T

Find #$$ if CFs areConstant


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$ationale for the #$$Method

#f #$$ L 3CC% then the pro-ect.srate of return is greater than its

cost66 so,e return is left over toboost stoc(holders. returns4

+'a,pleD

3CC ? 10% #$$ ? 184 9o this pro-ect adds e'tra return to

shareholders4


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>ecisions on Franchises 9and 5 per #$$

#f 9 and 5 are independent% acceptbothD #$$9 L r and #$$5 L r4

#f 9 and 5 are ,utually e'clusive%accept 9 because #$$9 L #$$54

#$$ is not dependent on the cost ofcapital used4


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Construct !" !ro&les

+nter CFs in CF5O and &nd !"5

and !"9 at diEerent discount

ratesD r !"5 !"9 0 80 0

8 AA 2G

10 1G 20

18 12

20 ;= 8


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!" !ro&le

I""L = 18.1%

I""S = 23.6%

Cosso&

Po'nt = 8.7%

S

L


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( I"")n* NPV + 0.

"&,&t.

NPV $/

%/I""

I"" ( )n* NPV ( 0

&t.

!" and #$$D o con:ictfor independent pro-ects4


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Mutually +'clusive !ro-ects

8.7

NPV $/

%/

I""S

I""L

L

S

+ 8.7%: NPVL( NPVS I""S ( I""LCNFLIC

( 8.7%: NPVS( NPVL I""S ( I""LN CNFLIC


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To Find the Crossover $ate

Find cash :ow diEerences between thepro-ects4 9ee data at beginning of the case4

+nter these diEerences in CF5O register%then press #$$4 Crossover rate ? 4@%rounded to 44

Can subtract 9 fro, 5 or vice versa andconsistently% but easier to have &rst CF

negative4 #f pro&les don.t cross% one pro-ect

do,inates the other4


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Two $easons !" !ro&lesCross

9iNe ;scale= diEerences4 9,aller pro-ectfrees up funds at t ? 0 for invest,ent4

The higher the opportunity cost% the,ore valuable these funds% so high rfavors s,all pro-ects4

Ti,ing diEerences4 !ro-ect with faster

paybac( provides ,ore CF in earlyyears for reinvest,ent4 #f r is high%early CF especially good% !"9 L !"54


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$einvest,ent $ate3ssu,ptions

!" assu,es reinvest at r;opportunity cost of capital=4

#$$ assu,es reinvest at #$$4 $einvest at opportunity cost% r% is

,ore realistic% so !" ,ethod is

best4 !" should be used to choosebetween ,utually e'clusivepro-ects4


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Modi&ed #nternal $ate of$eturn ;M#$$=

M#$$ is the discount rate thatcauses the !" of a pro-ect.s

ter,inal value ;T"= to e*ual the !"of costs4

T" is found by co,pounding in:ows

at 3CC4 Thus% M#$$ assu,es cash in:ows

are reinvested at 3CC4


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1040 040@040

0 1 2 A

10

@@40

12411841

61004010

10

T" in:ows

610040!" out:ows

M#$$ for Franchise 5D First%Find !" and T" ;r ? 10=


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A0

M#$$ ? 1@48 1841

0 1 2 A

610040

T" in:ows!" out:ows

M#$$5 ?

100?

1841;1IM#$$5=

A

9econd% Find >iscount$ate that +*uates !" and

T"


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To &nd T" with 12BD 9tep1% Find !" of #n:ows

First% enter cash in:ows in CF5OregisterD

CF0 ? 0% CF1 ? 10% CF2 ? @0% CFA ? 0

9econd% enter #/K$ ? 104

Third% &nd !" of in:owsD

!ress !" ? 114


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9tep 2% Find T" of #n:ows

+nter !" ? 6114% ? A% #/K$ ?10% !MT ? 04

!ress F" ? 18410 ? F" of in:ows4


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9tep A% Find !" of Out:ows

For this proble,% there is only oneout:ow% CF0 ? 6100% so the !" of

out:ows is 61004 For other proble,s there ,ay be

negative cash :ows for several

years% and you ,ust &nd thepresent value for all negative cash:ows4


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9tep % Find “#$$” of T" of#n:ows and !" of Out:ows

+nter F" ? 18410% !" ?6100% !MT ? 0% ? A4

!ress #/K$ ? 1@480 ? M#$$4


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hy use M#$$ versus #$$

M#$$ correctly assu,esreinvest,ent at opportunity cost ?

3CC4 M#$$ also avoids theproble, of ,ultiple #$$s4

Managers li(e rate of return

co,parisons% and M#$$ is betterfor this than #$$4


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!ro&tability #nde'

The pro&tability inde' ;!#= is thepresent value of future cash :ows

divided by the initial cost4 #t ,easures the “bang for the

buc(4”


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A

Franchise 5.s !" of FutureCash Flows

10 0@0

0 1 2 A10

!ro-ect 5D

G40GG48G

@0411

114G


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Franchise 5.s !ro&tability#nde'

!#5 ?

!" future CF

#nitial cost

114G

?

!#5 ? 141G

100

!#9 ? 141GG


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hat is the paybac(period

The nu,ber of years re*uired torecover a pro-ect.s cost%

or how long does it ta(e to get thebusiness.s ,oney bac(


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0

!aybac( for Franchise 5

10 0@0

0 1 2 A

6100

?

CFtCu,ulative 6100 6G0 6A0 80

!aybac(5 2 I A0/0 ? 24A8 years

0

24


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!aybac( for Franchise 9

0 2080

0 1 2 A

6100CFt

Cu,ulative6100 6A0 20 0

!aybac(9 1 I A0/80 ? 14@ years

0

14@

?


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9trengths andea(nesses of !aybac(

9trengthsD !rovides an indication of a pro-ect.s ris(

and li*uidity4 +asy to calculate and understand4

ea(nessesD #gnores the T"M4 #gnores CFs occurring after the paybac(

period4 o speci&cation of acceptable paybac(4


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A

10 0@0

0 1 2 A

CFt

Cu,ulative6100 6G04G1 614A2 14G

>iscountedpaybac(

2 I 14A2/@0411 ? 24 yrs

!"CFt 6100

6100

10

G40G G48G @0411

?

$ecover invest,ent I capital costs in 24

>iscounted !aybac(D )ses>iscounted CFs


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or,al vs4 onnor,alCash Flows

or,al Cash Flow !ro-ectD Cost ;negative CF= followed by a series of

positive cash in:ows4

One change of signs4

onnor,al Cash Flow !ro-ectD Two or ,ore changes of signs4

Most co,,onD Cost ;negative CF=% then stringof positive CFs% then cost to close pro-ect4

For e'a,ple% nuclear power plant or strip ,ine4


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8

#n:ow ;I= or Out:ow ;6= in Kear

0 1 2 A 8

6 I I I I I

6 I I I I 6

6 6 6 I I I

I I I 6 6 6

6 I I 6 I 6


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!avilion !ro-ectD !" and#$$

8%000%000 68%000%000

0 1 2r ? 10

600%000

+nter CFs in CF5O% enter #/K$ ? 104

!" ? 6A@%

#$$ ? +$$O$4 hy


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NPV Pof'&

450

-800

0 400100

I""2 = 400%

I""1 = 25%

%/

NPV $/

onnor,al CFsPTwo 9ignChanges% Two #$$s


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5ogic of Multiple #$$s

3t very low discount rates% the !" ofCF2 is large < negative% so !" Q 04

3t very high discount rates% the !"of both CF1 and CF2 are low% so CF0 do,inates and again !" Q 04

#n between% the discount rate hitsCF2 harder than CF1% so !" L 04 $esultD 2 #$$s4


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14 +nter CFs as before424 +nter a “guess” as to #$$ by

storing the guess4 Try 10D

10 9TO

#$$ ? 28 ? lower #$$

;9ee ne't slide for upper #$$=

Finding Multiple #$$s withCalculator


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ow guess large #$$% say% 200D

200 9TO

#$$ ? 00 ? upper #$$

Finding )pper #$$ withCalculator

h Th l CF


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0 1 2

600%000 8%000%000 68%000%000

!" out:ows R 10 ? 6%GA2%2A1404

T" in:ows R 10 ? 8%800%0004004

M#$$ ? 84@

hen There are onnor,al CFsand More than One #$$% )se

M#$$


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3ccept !ro-ect !

O4 $e-ect becauseM#$$ ? 84@ Q r ? 104

3lso% if M#$$ Q r% !" will benegativeD !" ? 6A@%4

9 d 5 M t ll


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9 and 5 are Mutually+'clusive and ill Be

$epeated% r ? 10

0 1 2 A

9D 6100

5D 6100

@0

AA48

@0

AA48 AA48 AA48

oteD CFs shown in Thousands

!" !" b t i 5


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!"5 L !"9% but is 5

better

9 5

CF0 6100 6100

CF1 @0 AA48

S 2

#/K$ 10 10

!" 41A2 @41G0

+ i l 3 l 3 i


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+*uivalent 3nnual 3nnuity3pproach ;+33=

Convert the !" into a strea, ofannuity pay,ents with the sa,e !"4

9D ?2% #/K$?10% !"?641A2% F" ?04 9olve for !MT ? +339 ? 24A4

5D ?% #/K$?10% !"?6@41G0% F" ?

04 9olve for !MT ? +335 ? 14G84 9 has higher +33% so it is a better

pro-ect4

! t ! - t C


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!ut !ro-ects on Co,,onBasis

ote that Franchise 9 could berepeated after 2 years to generate

additional pro&ts4 )se replace,ent chain to put on

co,,on life4

oteD e*uivalent annual annuityanalysis is alternative ,ethod4

$eplace,ent Chain 3pproach


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$eplace,ent Chain 3pproach;000s=

Franchise 9 with $eplication

!" ? 484

0 1 2 A

9D 6100 @0

6100 @0

@0

6100 60 @0@0 @0@0


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8

Co,pare to Franchise 5 !" ?@41G04

0 1 2 A

41A2A418

48

41A210

Or% )se !"s


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9uppose Cost to $epeat 9 in Two Kears $ises to 108%000

!"9 ? A418 Q !"5 ? @41G04

ow choose 54

0 1 2 A

9D 6100

@0 @06108 68

@0 @0

10%

+ i 5if


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+cono,ic 5ife versus!hysical 5ife

Consider another pro-ect with a A6year life4

#f ter,inated prior to Kear A% the,achinery will have positivesalvage value4

9hould you always operate for thefull physical life 9ee ne't slide for cash :ows4

+ i 5if


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+cono,ic 5ife versus!hysical 5ife ;Continued=

Kear CF 9alvage"alue

0 68%000 8%000

1 2%100 A%100

2 2%000 2%000

A 1%80 0

CF ) d + h


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CFs )nder +ach3lternative ;000s=

KearsD 0 1 2 A

14 o ter,ination 68 241

2 148

24 Ter,inate 2 years 68 241

A4 Ter,inate 1 year 68 842


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!"s under 3lternative 5ives;Cost of Capital ? 10=

!";A years= ? 612A4

!";2 years= ? 2184

!";1 year= ? 62A4


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Conclusions

The pro-ect is acceptable only ifoperated for 2 years4

3 pro-ect.s engineering life doesnot always e*ual its econo,ic life4

Choosing the Opti,al


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@8

Choosing the Opti,alCapital Budget

Finance theory says to accept allpositive !" pro-ects4

Two proble,s can occur when thereis not enough internally generatedcash to fund all positive !"

pro-ectsD 3n increasing ,arginal cost of capital4

Capital rationing

#ncreasing Marginal Cost


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#ncreasing Marginal Costof Capital

+'ternally raised capital can havelarge :otation costs% which

increase the cost of capital4 #nvestors often perceive large

capital budgets as being ris(y%

which drives up the cost of capital4

o&.../


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#f e'ternal funds will be raised%then the !" of all pro-ects should

be esti,ated using this higher,arginal cost of capital4


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Capital $ationing

Capital rationing occurs when aco,pany chooses not to fund all

positive !" pro-ects4 The co,pany typically sets an

upper li,it on the total a,ount of

capital e'penditures that it will,a(e in the upco,ing year4

o&.../


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$easonD Co,panies want to avoid thedirect costs ;i4e4% :otation costs= andthe indirect costs of issuing new capital4

9olutionD #ncrease the cost of capital byenough to re:ect all of these costs% andthen accept all pro-ects that still have a

positive !" with the higher cost ofcapital4

o&.../


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$easonD Co,panies don.t haveenough ,anagerial% ,ar(eting% or

engineering staE to i,ple,ent allpositive !" pro-ects4

9olutionD )se linear progra,,ing

to ,a'i,iNe !" sub-ect to note'ceeding the constraints onstang4

o&.../


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$easonD Co,panies believe that thepro-ect.s ,anagers forecast unreasonablyhigh cash :ow esti,ates% so co,panies

“&lter” out the worst pro-ects by li,itingthe total a,ount of pro-ects that can beaccepted4

9olutionD #,ple,ent a post6audit processand tie the ,anagers. co,pensation to thesubse*uent perfor,ance of the pro-ect4

Ch10 Basics of Capital Budgeting

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Transcript of Ch10 Basics of Capital Budgeting