Principles of Capital Budgeting
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Transcript of Principles of Capital Budgeting
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Principles of Capital Budgeting
Project classifications
Role of financial analysis
Cash flow estimation
Breakeven and profitability measures
The post audit
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What is capital budgeting?
Analysis of potential additions to a business’ fixed assets.
Such decisions:Typically are long-term in nature.Often involve large expenditures.Usually define strategic direction.
Thus, such decisions are very important to a business’ future.
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Project Classifications
For analysis purposes, projects are classified according to purpose and size. For example,Mandatory replacementExpansion of existing servicesExpansion into new services
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Role of Financial Analysis
For investor-owned firms, financial analysis identifies those projects that are expected to contribute to shareholder wealth.
For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’ financial condition.
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Overview of Capital Budgeting Financial Analysis
1. Estimate the capital outlay.
2. Forecast the cash inflows:Operating flowsTerminal flows
3. Assess the project’s riskiness.
4. Estimate the cost of capital.
5. Measure the financial impact.
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Key Concepts in Cash Flow Estimation
Incremental cash flows:
Inc. CF = CF(w/ project) - CF(w/o project).
Cash flow versus accounting income
Cash flow timing
Project life
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Key Concepts (Cont.)
Sunk costs
Opportunity costs:For capitalFor other resources
Effects on other business lines
Shipping and related costs
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Key Concepts (Cont.)
Working capital effects:Current assetsCurrent liabilities
Inflation effects
Strategic value
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Cash Flow Estimation Example
Assume Northwest Healthcare, a not-for-profit hospital, is evaluating a new piece of diagnostic equipment
Cost:$200,000 purchase price$40,000 shipping and installation
Expected life = 4 years.
Salvage value = $140,000.
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Utilization = 5,000 scans/year.
Charge = $80 per scan.
Variable cost = $40 per scan.
Fixed costs = $100,000.
Corporate cost of capital = 10%.
Cash Flow Estimation Example (Cont.)
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Time Line Setup
0 1 2 3 4
OCF1 OCF2 OCF3 OCF4InitialCosts(CF0)
+Terminal CF
NCF0 NCF1 NCF2 NCF3 NCF4
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Equipment $200
Installation & Shipping 40
Net investment outlay $240
Investment at t = 0 (000s)
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Operating cash flows (000s)
1 2 3 4Revenues $400 $400 $400 $400Total VC 200 200 200 200
Depreciation 25 25 25 25BT op. inc. $ 75 $ 75 $ 75 $ 75
Taxes -- -- -- --$ 75 $ 75 $ 75 $ 75
Depreciation 25 25 25 25Net op. CF $100 $100 $100 $100
AT op. inc.
Fixed costs 100 100 100 100
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Should the CFs on the previous slide have included interest expense
or dividends?
No. Financial costs are accounted for by discounting the net cash flows at the 10% corporate cost of capital. Thus, deducting interest or dividends from the estimated cash flows would be “double counting” financing (capital) costs.
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Terminal cash flows at t = 4 (000s)
Salvage value $140Tax on SV 0 Net terminal CF $140
How are salvage value taxes determined for investor-owned firms?
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Suppose $5,000 had been spent last year to improve the space for the new
diagnostic equipment. Should this cost be included in the analysis?
No. This is a sunk cost. The money has already been spent, so project acceptance would have no effect on that flow. Cash flows in the analysis must be incremental to the project.
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Suppose the space could be leased out for $12,000 a year. Would this
affect the project’s cash flows?
Yes. Accepting the project means that Northwest Healthcare is foregoing a $12,000 cash inflow. This is an opportunity cost that should be charged to the project.
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If the new equipment would decrease patient utilization of existing services,
would this affect the analysis?
Yes. The effect on other CFs within the business is an “externality.”
The net CF loss each year on other services would be a cost to this project.
Externalities can be either positive or negative.
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0
100
1
100
2
100
3
100
4
-240140240
Net cash flows (000s)
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If this were a replacement rather than a new (expansion) project, would the
analysis change?
The relevant operating CFs would be the difference between the CFs on the new and old equipment.
Also, selling the old equipment would produce an immediate cash inflow, but the salvage value at the end of its original life is foregone.
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Breakeven Analysis
There are many different approaches to breakeven in project analysis:Time breakevenInput variable breakeven
• Utilization• Charge
We will focus on payback (or payback period), a measure of time breakeven.
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What is the project’s payback?
0
100
1
100
2
100
3
240
4
-240
Cumulative CFs:
60-240 -40-140 300
Payback = 2 + 40 / 100 = 2.4 years.
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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 time value.
2. Ignores all CFs occurring after the payback period.
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Profitability Analysis
Profitability analysis focuses on a project’s return.
As with any investment, returns can be measured either in dollar terms or in rate of return (percentage) terms.Net present value (NPV) measures a
project’s dollar return.Internal rate of return (IRR) measures a
project’s rate of return.
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Net Present Value (NPV)
NPV is merely the sum of the present values of the project’s net cash flows.
The discount rate used is called the project cost of capital. If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%.
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What is the project’s NPV?
0
100
1
100
2
100
3
240
4
-240.00
10%
90.9182.6475.13
163.93172.61 = NPV
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Financial Calculator Solution
Enter in CFj registers:
-240
100
100
100
240
CF0
CF1
NPV
CF2
CF3
I
Then:
= 10
And solve for:
CF4
= 172.61
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Interpretation of the NPV
NPV is the dollar contribution of the project to the equity value of the business.
A positive NPV signifies that the project will enhance the financial condition of the business.
The greater the NPV, the more attractive the project financially.
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Internal Rate of Return (IRR)
IRR measures a project’s percentage (rate of) return.
It is the discount rate that forces the PV of the inflows to equal the cost of the project. In other words, it is the discount rate that forces the project’s NPV to equal $0.
IRR is the project’s expected rate of return.
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What is the project’s IRR?
0
100
1
100
2
100
3
240
4
-240.00????
0.00 = NPV
IRR = ?
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What is the project’s IRR? (Cont.)
0
100
1
100
2
100
3
240
4
-240.0073.8454.5340.2771.36
0.00 = NPV
IRR = 35.4%
Therefore, IRR = 35.4%.
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Calculator Solution
Enter in CFj registers:
-240
100
100
100
240
CF0
CF1IRR
CF2
CF3
And solve for:
CF4
= 35.4%
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Interpretation of the IRR
If a project’s IRR is greater than its cost of capital, then there is an “excess” return that contributes to the equity value of the business.
In our example, IRR = 35.4% and the project cost of capital is 10%, so the project is expected to enhance Northwest’s financial condition.
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k > IRRand NPV < 0.
Value is decreased.
NPV ($)
Cost ofCapital (%)
IRR
IRR > kand NPV > 0.
Value is increased.
Comparison of NPV and IRR
Here, k = project cost of capital.
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Capital Budget Decision Making
Responsibility resides with:Senior-level management/GB for
expansion-type capital projectsMid-level management for replacement-
type capital projectsDecision criteria summary
Strategic importance of project“Appropriate” project returns anticipated“Manageable” level of project risk
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Capital Budget Decision Making
Evaluating projects with unequal livesMutually exclusive projects having different
useful life periodsComparing apples to oranges
Evaluation methodsReplacement chain analysis method
• “Force” projects to have equal lives by allowing unlimited replication
• Assumes that cash flow projections and cost of capital won’t change upon replication
• Difficulty in finding “lowest common denominator” for similar project lives (5 vs. 6)
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Capital Budget Decision Making
Equivalent Annual Annuity MethodGiven projected project NPV, estimate
“implied” annuity (PMT) associated with stream of cash flows
Enter NPV as PV in calculator, cost of capital as ‘I’, and # of years as N, find PMT
Project with highest estimated EAA is preferred
Like RCA method, assumes that projects can be costlessly replicated indefinitely.
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Capital Budgeting in NFP Businesses
Measures thus far have focused on the financial impact of a project.
Presumably, NFPs have important goals besides financial ones. Other considerations can be incorporated into the analysis by using:The net present social value (NPSV)
model.
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Capital Budgeting in NFP Businesses
TNPV = NPV (fin.) + NPSV (social)Preferred projects have high TNPVNo investments in projects where
NPSV < 0 (regardless of NPV)Average TNPV for all projects = 0Estimation of NPSV -- willingness to
pay methodology (conceptual)The “social” cost of capital
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Post Audit
The post audit is a formal process for monitoring a project’s performance over time.
It has several purposes:Improve forecastsDevelop historical risk dataImprove operationsReduce losses