Chapter 5 Capital Budgeting

1 Chapter 5 Capital BudgetingRoad MapPart AIntroduction to BValuation of assets, given discount rates. Fixed-Income securities. Common stocks. Real assets ( Capital Budgeting ).Part CDetermination of risk-adjusted discount DIntroduction to Issues NPV Rule Cash Flow Calculations Alternatives to NPV RuleChapter 5 Capital Budgeting5-11 NPV RuleA firm s business involves Capital investments ( Capital Budgeting ), , the acquisition of real assets. The objective is to increasethe firm s current market value. Decision reduces to valuing realassets, , their cash the cash flow of an investment (a project) be{CF0,CF1, ,CFt}.Its current market value isNPV=CF0+CF11+r1+ +CFt(1+rt) is the increase in firm s market value by the Criteria:1.

2 For a single project, take it if and only if its NPV is For manyindependentprojects, take all those with Formutually exclusiveprojects, take the one with positive andhighest 2006c J. Lecture Notes5-2 Capital BudgetingChapter 5In order to compute the NPV of a project, we need to analyze1. Cash flows2. Discount rates3. Strategic focus on cash flow here and return to discount rate (Part C)and strategic options (Part D) Lecture Notesc J. WangFall 2006 Chapter 5 Capital Budgeting5-32 Cash Flow CalculationsMain Points:1. Use cash flows, not accounting Use after-tax cash Use cash flows attributable to the project (compare firm valuewith and without the project): Use incremental cash flows.

3 Forget sunk costs: bygones are bygones. Include investment in working Capital as Capital expendi-ture. Include opportunity costs of using existing 2006c J. Lecture Notes5-4 Capital BudgetingChapter 5In what follows, all cash flows are attributable to the [Project Cash Inflows] [Project Cash Outflows]=[Operating Revenues] [Operating Expenses without depreciation] [ Capital Expenditures] [Taxes].Defining operating profit byOperating Profit=Operating Revenues Operating Expenses w/o DepreciationLet denote the effective tax rate. The income taxes are[Taxes]=( )[Operating Profit] ( ) [Depreciation].Accounting depreciation affects cash flows because it reduces thecompany s tax (1 )[Operating Profits] [ Capital Expenditures]+( )[Depreciation].

4 Lecture Notesc J. WangFall 2006 Chapter 5 Capital Use Cash Flows, Not Accounting Earnings vs. Cash machine purchased for $1,000,000 with a life of 10 yearsgenerates annual revenues of $300,000 and operating expenses of$100,000. Assume that machine will be depreciated over 10 yearsusing straight-line depreciation. The corporate tax rate is 40%.DateAccounting EarningsAccounting EarningsCash Flow After-taxBefore TaxAfter Tax000- 1,000,0001300,000 - 100,000 - 100,000 =( )(100,000) =( ) (300,000-100,00) +100,00060,00040,000 = 160,0002100,00060,000160,0003100,00060,0 00160,0004100,00060,000160,0005100,00060 ,000160,0006100,00060,000160,0007100,000 60,000160,0008100,00060,000160,0009100,0 0060,000160,00010100,00060,000160,000 The accounting earnings donotaccurately reflect the actualtiming of cash 2006c J.

5 Lecture Notes5-6 Capital BudgetingChapter Use After-tax Cash the following project (the cash flow is inthousands of dollars and tax rate is 50%):Year012345 Invest500 Operating CF0100300300300 Depreciation100100100100100 Income-1000200200200 Tax-500100100100 After-tax CF-50050100200200200PV at 10%-500 + Lecture Notesc J. WangFall 2006 Chapter 5 Capital Investment In WC Is A Capital ExpenditureTypically, there are timing differences between the accountingmeasure of earnings (Sales - Cost of Goods Sold) and cash Capital (WC)=Inventory+A/R in working Capital Inventory: Cost of goods sold includes only the cost of itemssold. When inventory is rising, the cost of goods sold under-states cash outflows.

6 When inventory is falling, cost of goodssold overstates cash outflows. Accounts Receivable (A/R): Accounting sales may reflect salesthat have not been paid for. Accounting sales understate cashinflows if the company is receiving payment for sales in pastperiods. Accounts Payable (A/P) conceptually the reverse of 2006c J. Lecture Notes5-8 Capital BudgetingChapter run a chain of stores that sell sweaters. Thisquarter, you buy 1,000,000 sweaters at a price of $ the next two quarters, you sell 500,000 sweaters each quarterfor $ each. The corporate tax rate is 40%. In million dollars,your cash flows areDateAfter Tax ProfitInventoryCash Flow00(1)(30) = 30-301( )(60-30)( ) = 9( )(30) = 15( )(60) - ( )(60-30)( ) = 242( )(60-30)( ) = 90( )(60) - ( )(60-30)( ) = 24 Note:Cash flow=Profit (after tax) Change in Lecture Notesc J.

7 WangFall 2006 Chapter 5 Capital Use Market ValuationExample. Reopen King Solomon s mine: Initial investment $ M Capacity million oz for a life of 1year Production cost $200 per oz Current gold priceP0= $400per oz Forecasted gold price growth 5% by bearish manager Discount rate 10%.NPV using the forecast:NPV= +( )(420) $ , gold pays no dividend. Thus,P0=PV(P1)andNPV= Investment+PV(Payoff))= +PV( P1)= + 40 = +$ today s gold 2006c J. Lecture Notes5-10 Capital BudgetingChapter 5 Example(Gromb). MSW Inc. is considering the introduction ofa new product: Turbo-Widgets (TW). TW were developed at an R&D cost of $1M over past 3 years New machine to produce TW would cost $2M New machine lasts for 15 years, with salvage value of $50,000 New machine can be depreciated linearly to $0 over 10 years TW need to be painted; this can be done using excess capacityof the painting machine, which currently runs at a cost of$30,000 (regardless of how much it is used) Operating cost: $40,000 per year Sales: $400,000, but cannibalization would lead existing salesof regular widgets to decrease by $20,000 working Capital (WC): $250,000 needed over the life of theproject Tax rate: 34% Opportunity cost of Capital : 10%.

8 Question: What is the project s NPV ( , should MSW go aheadwith the production of TW)? Lecture Notesc J. WangFall 2006 Chapter 5 Capital Budgeting5-111. Initial investment includes Capital expenditure and WC2. R&D expense is a sunk cost3. Depreciation is $2M/10 = $ for first 10 years4. Project should not be charged for painting-machine time5. Project should be charged for cannibalization of regular widgetsales6. Salvage value is fully taxable since the book value at the endof year 10 is $0 (the machine cost has been fully depreciated).The cash flows (in thousand dollars) areYearCash Flow0- (2000+250) = -22501-10(400-40-20)( ) + (200)( ) = (400-40-20)( ) = + (50)( ) + 250 = $57, 2006c J.

9 Lecture Notes5-12 Capital BudgetingChapter 53 Project Interaction Often we have to decide on more than one project. For mutually independent projects, we just apply the NPV ruleto each one of them. For projects dependent of each other ( , mutually exclusive accepting one rules out the others), we have to compare demand for your product is projected toincrease over time. If you start the project early, your competitorswill catch up with you faster, by copying your idea. Youropportunity cost of Capital is 10%. Denoting by FPV the project sNPV at the time of introduction, we have:Year to StartFPV % Change in FPV NPV1100 912120209931381510441498102 Before year 4, the return to waiting is larger that the opportunitycost of Capital , 10%.

10 As long as the growth rate of FPV remainsbelow 10% after year 4, it is best to wait and introduce at theend of year Lecture Notesc J. WangFall 2006 Chapter 5 Capital Budgeting5-134 Alternatives to NPVIn practice, investment rules other than NPV are also used: Payback Period Profitability Index (PI) Internal Rate of Return (IRR)Firms use these rules because they were used historically and theymay have worked (in combination with common sense) in theparticular cases encountered by these rules sometimes give the same answer as NPV, but ingeneral they do not. We should beaware of their shortcomingsand use NPV whenever bottom line is:The NPV rule dominates these alternative 2006c J.