Capital Budgeting: Steps, Cash Flows, and Discount Rates - Prof. Terrill R. Keasler, Study notes of Finance

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Chapter 3

Capital Budgeting and Project

Cash Flow Estimation

Capital Budgeting

Learning Objectives:  Learn what Capital Budgeting is and how to apply the principles to the investment projects that businesses purchase.  Learn new terms associated with Capital Budgeting  Learn how to construct estimated cash flows for capital budgeting purposes. Capital Budgeting is a process of allocating scarce capital resources to the investment projects that create the highest value. We will be discussing the analysis of corporate investments. Business professionals refer to capital budgeting as capital expenditures and they use the abbreviation CAPEX. Steps in the Capital Budgeting Process:  Identify investment projects:  Estimate cash flows  Determine the degree of certainty associated with the cash flows  Use an appropriate selection criteria to evaluate the cash flows (Payback, Net Present Value, Internal Rate of Return, Modified Internal Rate of Return, and Profitability Index.  Continue to monitor the project following its acceptance Examples of capital projects are an oil pipeline, heavy machinery, purchase of machinery to make semiconductor chips, etc. There are of course many other examples. Do you think the following project is acceptable to a company? Expected Cash Flows for each period are given. 0 1 2 3 4 5 ($100,000) $20,000 $60,000 $10,000 $10,000 $20,

Terms:

Independent and mutually exclusive projects What is the difference between independent and mutually exclusive projects? Mutually exclusive projects are where the decision to choose one project makes it impossible to choose another. Independent projects are where the decision to choose one project has no influence on the decision to choose another project. Discounting effects are associated with cash flows to be received in the future. There are two concepts that are associated with higher discounting effects:  Cash flows expected to be received in the more distant future are subject to more extreme discounting effects.  The higher the discount rate the higher the discounting effect. Payback period  Payback period is the length of time it takes for an investment project to return its initial cost.  Accept a project based on payback methodology if the calculated payback time length is less than the length of time designated by a firm’s management as the minimum acceptable time length. Advantages: Easy to use Says something about a project’s risk Disadvantages:

 Projects have large differences in their cost.  Projects have differences in the timing of their significant cash flows. Profitability Index (PI) The profitability index is the present value of the future expected cash flows divided by the cost of the investment. Accept a project if the PI is greater than or equal to 1. A PI greater than 1 indicates that a project has a positive NPV. A PI less than 1 indicates that a project has a negative NPV.

The appropriate discount rate for capital budgeting purposes

Weighted average cost of capital A firm's weighted average cost of capital is the appropriate discount rate to use for capital budgeting purposes if the risk of the project under evaluation is the same as the risk of the firm's other projects. A firm's weighted average cost of capital is the cost of debt capital, after tax, weighted by the percentage of debt in the firm's capital structure plus the firm's cost of equity capital weighted by the percentage of equity in the firm's capital structure. Relevant cash flows Cash flows that will change with the acceptance of a project are the relevant cash flows for capital budgeting purposes. These cash flows are often referred to as incremental cash flows. Cash flows and not an accounting income definition are used in determining if an investment project should be accepted. Initial outlay The initial outlay of an investment project is the initial cost of the investment plus any shipping and installation costs as well as the working capital (inventory, receivables, etc.) investment required to facilitate operation. Depreciable basis A project's depreciable basis is the initial cost of the investment plus any shipping and installation costs. Incremental Cash Flows Always use incremental cash flows to evaluate an investment project. Use after-tax cash flows. Sunk costs are not considered a relevant cash flow. Sunk costs are the costs that have previously been paid for and will have no influence on the investment decision. Drug development costs are an example. Opportunity costs are relevant costs. Suppose a cattle farmer has 50 cows on 100 acres and the farmer makes $100 per year on each cow. Now suppose the farmer wants to go into the catfish business and builds a pond on the 100 acres. With the pasture land converted to a lake the farmer is giving up a cash flow of $5,000 per year (50 cows * $100). The $5,000 amount is an opportunity cost that must be subtracted from the expected cash flows of the catfish operation. Inflation has an impact on cash flows and should be factored into cash flow estimation. Interest expense is not a relevant cash flow for capital budgeting purposes in the sense that interest expense is not included in capital budgeting cash flows directly. Interest expense is incorporated through the Weighted Average Cost of Capital. This is true even when a firm borrows money to fund a project. How do we incorporate interest expense into a capital budgeting problem? Interest expense is accounted for through the discount rate. The weighted average cost of capital (WACC) incorporates the component cost of debt as a percentage of debt in a firm's capital structure. Summary:

The relevant cash flows to consider in a capital budgeting project analysis are all incremental cash flows, after-tax cash flows, working capital related cash flows, certain cash flows related to the initial outlay and terminal year, as well as, opportunity costs. Terminal year cash flows The cash flow in the last year of a project is the terminal year cash flow. When a project is sold there is no longer a need for the associated working capital so the previous investment in working capital is recovered. Also, if an investment is sold at a price higher than its book value, the gain is subject to tax. A firm's capital budgeting analyst needs to keep up with a project's book value. Suppose a project has an initial depreciable basis of $100,000. Also suppose the following hypothetical depreciation rates apply for each year. The firm’s marginal tax rate is expected to be 20%. Year 1 33% Year 2 45% Year 3 15% Year 4 7% Depreciation year 1 = $100,000 * 33% = $33,000: Book Value end of year = $67, Depreciation year 2 = $100,000 * 45% = $45,000: Book Value end of year = $22, Depreciation year 3 = $100,000 * 15% = $15,000: Book Value end of year = $7, Depreciation year 4 = $100,000 * 7% = $7,000: Book Value end of year = $ If the project is sold for a salvage value of $10,000 at the end of year 3 the gain on the project will be $10,000 - $7,000 = $3,000. The tax on the gain is $3,000 * 20% = $ The cash flow from the sale of the project is $10,000 - $600 = $9,400.

Risk analysis in Capital Budgeting

 Sensitivity Analysis - How changes in one variable influence a project's profitability.  Scenario analysis - How changes in more than one variable influence a project's profitability. Higher risk projects require higher discount rates. Capital Budgeting - Problems

1. B D Crockett Inc. is considering two investment proposals. The firm wishes to know the payback period of the following investments. Calculate the payback period for each project. Assume cash flows arrive uniformly throughout the year. For example a cash flow of $12,000 per year is $12, / 12 per month. CASH FLOWS CASH FLOWS PROJECT A PROJECT B Cumulative Cumulative Expected Expected YEAR ($100,000) ($100,000) 1 30,000___________ 80,000__________ 2 40,000___________ 24,000__________ 3 36,000___________ 80,000__________ 4 20,000___________ 10,000__________ 5 0___________ 50,000__________ 6 0___________ 60,000__________ Payback(A)_______ Payback(B)_______ Answer Payback A 2 years 10 months. Payback B 1 year 10 months
2. J D Most Inc. is considering two investment proposals. The firm wishes to know the payback of the following investments. Calculate the payback period for each project. Assume cash flows arrive uniformly throughout the year. For example a cash flow of $12,000 per year is $12,000 / 12 per month.

4% each year for the life of the project which is 4 years. The cost per item in the first year is expected to be $50 per unit and this cost is expected to increase by 4% each year. Management expects the salvage value of the machine at the end of 4 years to be $1,000. The firm’s accountant (who assumed a zero salvage value for bookkeeping purposes) is depreciating the machine using the MACRS rates BELOW: Year 1 33% Year 2 45% Year 3 15% Year 4 7% The firm’s marginal tax rate is expected to be 30%. Management expects that working capital (inventory, receivables, etc.) needs will immediately rise at time zero by $10,000 and increase by $500 each year through year three (for example, in year 1 the amount of incremental working capital will be $500 , not $10,500). At the end of the project’s life, year 4, the working capital investment, in all years prior to the last year, will be recovered. Hint: The recovery in year 4 will be $11,500. This project is similar in risk to the firm’s existing projects and the required return on this risk class project is 10% after tax. Calculate the Project’s NPV and IRR. Is the project acceptable?? Yes Why? The NPV is not negative.

6. Diversified Technologies Inc. Is considering the following investment project. The cost of the investment is $200,000. This initial investment includes the cost of installing the investment. Diversified Technologies can sell 10,000 pieces of product per year at $60 the first year. Management expects the price to increase by 3% each year for the life of the project which is 4 years. The cost per item in the first year is expected to be $45 per unit and this cost is expected to increase by 2% each year. Management expects the salvage value of the machine at the end of 4 years to be $3,000. The firm’s accountant (who assumed a zero salvage value for bookkeeping purposes) is depreciating the machine using the MACRS rates BELOW: Year 1 33% Year 2 45% Year 3 15% Year 4 7% The firm’s marginal tax rate is expected to be 20%. Management expects that working capital (inventory, receivables, etc.) needs will immediately rise by $20,000 and increase by $1500 each year through year three (year 1 incremental working capital is $1,500 not $20,000). At the end of the project’s life, year 4, the working capital investment, in all years prior to the last year, will be recovered. This project is similar in risk to the firm’s existing projects and the required return on this risk project is 8% after tax. Calculate the Project’s NPV and IRR. Is the project acceptable? Yes Why? The NPV is not negative.

7.a. Calculate the Internal Rate of Return (IRR) of the following cash flows. The investment costs $10,000 today. Investors require a return of 14%:Answer 36.108% 0 1 2 3 4 5 ($10,000) $4,000 $6,000 $4,000 $4,000 $5, b. Is the project acceptable at the required return of 14%? Yes. Why? IRR > Required Return c. Is the IRR an appropriate reinvestment rate? Not Usually. Why? The firm’s cost of capital is a more appropriate reinvestment rate. IRR’s much greater than a firm’s capital cost, might not easily, and over time, be duplicated. d. Calculate the Modified IRR (MIRR) of the cash flows. Investors require a return of 12% on reinvested capital. Answer 23.92%

8. Calculate the Modified IRR (MIRR) of the following cash flows. Investors require a return of 12% on reinvested capital. Answer 20.5% 0 1 2 3 4 5 ($10,000) $4,000 $4,000 $4,000 $4,000 $4, 9.a. Calculate the Internal Rate of Return (IRR) of the following cash flows. The investment costs $10,000 today: Answer 15.2382% 0 1 2 3 4 5 ($10,000) $3,000 $3,000 $3,000 $3,000 $3, b. Is the project acceptable at the required return of 10%? Yes. Why? The IRR is greater than the required return. c. Is 15.23% an appropriate reinvestment rate? No. Why? A firm cannot usually reinvest at an IRR greater than the firm’s cost of capital, in a competitive environment.
9. What is the difference between independent and mutually exclusive projects? Mutually exclusive projects are where the decision to choose one project makes it impossible to choose another. Independent projects are where the decision to choose one project has no influence on the decision to choose another project.
10. List two situations where IRR and NPV project selection methods can give conflicting accept/reject decisions.

1. If there is a significant difference in the timing of the significant cash flows.
2. If there is a difference in the scale (cost) of the projects.

12. List the advantages and disadvantages of the payback period methodology. Advantages

1. Easy to use
2. Payback says something about the project’s risk Disadvantages
3. Does not consider cash flows beyond the payback period
4. Does not use the time value of money.

13. List the problems with the IRR methodology.

1. The internally calculated IRR is usually not an appropriate reinvestment rate.
2. There can be multiple IRR’s.

14. Refer to Appendix A. Examine the following project’s expected cash flows. Charlotte Fabrics Inc. is considering projects A and B for purchase and the two projects are mutually exclusive. You have just

Expected Expected Expected Cash Flows Cash Flows Cash Flows Year (^) Investment A Investment B Project Delta 0 -10,000.00 -10,000.00 0. 1 1,000.00 4,100.00 (3,100.00) 2 1,000.00 4,100.00 (3,100.00) 3 4,300.00 4,100.00 200. 4 4,300.00 1,000.00 3,300. 5 4,300.00 1,000.00 3,300. Answers intentionally omitted on question 15 for you to practice writing.

15. Examine the following project’s expected cash flows. Charlotte Fabrics Inc. is considering projects A and B for purchase and the two projects are mutually exclusive. You have just been appointed senior analyst in the Finance office and you must be ready to answer any questions relating to the two projects cash flows at the upcoming board meeting. Answer the following questions: a. Which investment would you purchase? Why? b. Does the Discount rate have an impact on the decision? c. The purchase decision may be influenced by whether or not the projects are mutually exclusive. Under what circumstance(s)? d. Which investment has the highest IRR? Why? e. Which investment has the highest NPV at low discount rates? Why? f. At what rate is the NPV of the two projects equal? What is the significance of this rate? g. Assume the discount rate appropriate for these investments is 4% as the projects are low risk. Also assume the projects are mutually exclusive. Which project would you advise the Board of Directors to purchase? Why? h. Assume the discount rate appropriate for these investments is 14%. Also assume the projects are mutually exclusive. Which project would you advise the Board of Directors to purchase? Why? i. Which investment’s NPV is more sensitive to changes in the discount rate? Why? Expected Expected Expected Cash Flows Cash Flows Cash Flows Year (^) Investment A Investment B Project Delta

16a. What are the accept/reject criteria for projects using the NPV method? Answer: Accept if NPV >= 0 Reject if NPV < 0 b. Why is a project acceptable with a NPV equal to zero? Answer: The project just returns to investors their required return. Remember, the definition of the IRR is that discount rate (required return) that makes the NPV equal to zero. 17a. What are the accept/reject criteria for projects using the IRR method? Answer: Accept if IRR >= Cost of Capital, Required Return, Discount Rate Reject if IRR < Cost of Capital, Required Return, Discount Rate 17a. What are the accept/reject criteria for projects using the Pure Payback method? Accept if the project’s payback period is less than the maximum payback period determined by management.

18. What is a hurdle rate? Answer: This is the same as the discount rate, required return, or cost of capital. A rate you must get over if the project will be beneficial to the firm.
19. Why does the teacher always talk about the Cost of Capital, Required Return, and Discount Rate and not just use one term? Seems like all of these terms are confusing so why not just stick to one? Answer: In the financial press and the business world these terms are used interchangeably and you must know that they mean the same thing.
20. What is the relation between IRR and NPV? If NPV >= 0 this implies that IRR >= Cost of Capital If NPV < 0 this implies that IRR < Cost of Capital 21a. Which mutually exclusive investment will you purchase? Why? The discount rate is 12%. Project A Project B Cost $100,000 $1,000, One Year Cash Flow $130,000 $1,200,

• Appendix A #

Expected Expected Expected

Cash Flows Cash Flows Cash Flows

Year Investment A Investment B Project Delta

NPV PROFILE # 14

WACC or Rate NPV Investment A NPV Investment B NPV Project Delta 1.00% $4,367.45 $3,970.49 $396. 2.00% $3,860.72 $3,653.50 $207. 3.18% $3,296.07 $3,296.07 ($0.00) 4.00% $2,918.72 $3,054.60 ($135.88) 5.00% $2,480.70 $2,771.55 ($290.85) 6.00% $2,062.97 $2,498.70 ($435.73) 7.00% $1,664.39 $2,235.58 ($571.19) 8.00% $1,283.88 $1,981.71 ($697.83) 9.00% $920.43 $1,736.66 ($816.23) 10.00% $573.11 $1,500.03 ($926.92) 11.75% $0.00 $1,103.97 ($1,103.97) 12.00% ($76.63) $1,050.45 ($1,127.08) 13.00% ($380.64) $836.80 ($1,217.45) 14.00% ($671.73) $630.14 ($1,301.87) 15.00% ($950.57) $430.15 ($1,380.73) 17.27% ($1,540.64) $0.00 ($1,540.64) 17.50% ($1,598.17) ($42.48) ($1,555.70) 18.00% ($1,719.78) ($132.58) ($1,587.20)

NPV PROFILE # 15

Growth Rate Value Cost $ 50.00 33% Cost Growth Rate 4.00% 7% Salvage Value After Tax

Discount Rate 10.00% Initial Investment $ 200, $ 66,000 $ 90,000 $ 30,000 $ 14, Depreciation Percentages

Revenue $ 600,000 $ 624,000 $ 648,960 $ 674, Cost 500,000 520,000 540,800 562, Gross Profit 100,000 104,000 108,160 112, Depreciation 66,000 90,000 30,000 14, EBIT 34,000 14,000 78,160 98, TAX 10,200 4,200 23,448 29, Net Income 23,800 9,800 54,712 68, Net Income Plus Depreciation

Working Capital (10,000) (500) (500) (500) 11, Total Initial Cash Outlay

Salvage Value 700 Net Cash Flow $(210,000) $ 89,300 $ 99,300 $ 84,212 $ 95, Net Present Value $81, IRR 27% The information highlighted below is often given on the test to help you jump start a problem.

Spreadsheet Solution to Problem

Units 10,000 Tax Rate 20%

Price $ 60.00 Price Price Growth Rate 3.00% Salvage $ 3, Cost $ 45.00 Cost Cost Growth Rate 2.00% 7% Salvage Discount Rate 8.00% After Tax 2400 Initial Investment $ 200, $ 66,000 $ 90,000 $ 30,000 $ 14, Depreciation Percentages

Revenue $ 600,000 $ 618,000 $ 636,540 $ 655, Cost 450,000 459,000 468,180 477, Gross Profit 150,000 159,000 168,360 178, Depreciation 66,000 90,000 30,000 14, EBIT 84,000 69,000 138,360 164, TAX 16,800 13,800 27,672 32, Net Income 67,200 55,200 110,688 131, Net Income + Depreciation

Working Capital (20,000) (1,500) (1,500) (1,500) 24, Total Initial Cash Outlay

Salvage Value 2, Net Cash Flow $(220,000) 131,700 143,700 139,188 $ 172, Net Present Value at an 8% discount Rate

IRR 52.24%

Net Present Value at a zero discount Rate

Since the expected return to a company from a capital investment project is an additional (incremental) return the cost of capital used to discount the expected cash flows should be an incremental cost rather than a historical cost. The incremental cost of capital is a market value cost. The cost of debt is basically the before-tax rate of interest a company would have to pay in the current market environment in order to issue debt. Since interest on debt is generally tax deductible the after-tax cost of debt is used as the debt component cost. The expected cash flow stream from a capital investment project goes to the firm, to all components (providers) of capital, to provide a return to these capital components based on the capital components’ weighting in the market value capital structure. The capital budgeting specialist at a company should use the WACC as the discount rate when finding the present value of a stream of cash flows. The present value of a stream of cash flows is the amount you are willing to pay today for the cash flows. Equation 4 shows the present value of expected cash flows. When you subtract the cost of the investment you have the Net Present Value (NPV). Equation 4 – Present Value of Expected Cash Flows 

N t t t

WACC

ExpectedCash Flow

esent ValueofCash Flows

1 (^1 )

Pr....

Equation 5

. Pr.

1

CashFlowsat TimeZero

WACC

ExpectedCash Flow

Net esent Value

N t t

t 

 (^)   The capital budgeting specialist at a company must spend time estimating the expected cash flows and estimating the WACC. Notice I say estimating because in finance we are forward looking and in a company we do not know with certainty the values of future cash flows or the cost of capital required by the providers of capital. What we can do is understand the relationship between the discount rate and cash flow construction. In capital budgeting we have a stream of cash flows that are available to the company as a whole. The cash flows arrive into the company and there is no one at a company designated to separate the cash flows that go to debt and the cash flows that go to equity. The capital budgeting specialist separates the cash flows by determining the percentage market value weightings of debt and equity in a firm’s capital structure. The capital budgeting specialist determines the component cost of each capital component by finding the cost of each capital component and multiplying times the market value weighting of each component. If a company is totally equity funded the WACC will be a pure equity discount rate. The cost of equity will be the appropriate discount rate used to discount the cash flow stream because all of the cash flows will go to the shareholders. When a company has debt the return required by the debtholders must be paid and this is accounted for by taking the interest out of the cash flow stream by using a debt component in the WACC formula. Now this is important, if you use the WACC to take the interest out of your cash flow stream you should not deduct interest as a component of the cash flow construction. You take care of (remove or discount) the interest through the discounting process by using a WACC that has a debt component. A typical cash flow construction for capital budgeting purposes is shown in Cash Flow Construction 1. FIN 3680 Study Guide Exam # Spring 2008

 Know the steps in the capital budgeting process. Terms:  CAPEX  Independent projects  Mutually Exclusive projects  Discounting effects  Know the four terms (three other terms) that all have the same meaning as cost of capital.  Know the appropriate discount rate for capital budgeting purposes.  Know how to discuss the relevant cash flows for capital budgeting purposes.  Know how to calculate a terminal year cash flow including after-tax salvage value and return of working capital.  Know how to calculate the annual operating cash flows for a project.  Know about risk analysis in capital budgeting.  Know sensitivity and scenario analysis as methods of risk analysis in capital budgeting.  Beginning on page 95 in the course pack work problems 1, 2, 3, 4, 5, 6, 7b., c., and d., 8, 9, 10, 11, 12, 13, 14, and 15.  On page 101 work problems 16, 17, 18, 19, and 20.  On page 102 work problems 21 and 22.  Know the conceptual issues surrounding problems 14 and 15 in the Course Pack.  You will have to work a problem like #5 or #6 on page 97 of the course pack on the exam.  With respect to the timing of an investment project's largest cash flows, an investment project's NPV will be more sensitive to changes in the discount rate in what situation?  Explain interest expense as a relevant cash flow for capital budgeting purposes. How do we incorporate interest expense into a capital budgeting problem?  Know how to calculate the depreciable basis of a project.  Know how to calculate the initial outlay of a project.  Know that an investment project's NPV will be more sensitive to changes in the discount rate is the largest cash flows arrive later in the project’s life.  Know that an investment project is acceptable if it has a zero NPV because the investor is just earning the required return.  Know how to calculate the most one will pay for an investment project.  Know all about the following Project Selection Methods:  Payback period  Net Present Value  IRR  MIRR  Profitability Index Know how to calculate IRR and NPV using the financial calculator. For each project selection method know: Know accept/ reject criteria (Except for the MIRR). Know advantages and disadvantages or problems (if given in the course pack). Know how to calculate a number question for each method. Know when IRR and NPV might give conflicting results. Conceptual issues discussed in the course pack and in class.  Know that NPV is the value a firm should change if a project is selected.  Problems assigned in the textbook.  Know about depreciation and operating cash flow.  Know why interest expense is excluded from the annual operating cash flow definition. Know specific information referred to in the course pack during class.