FINA: EXAM 3

Capital Budgeting

• Analysis of Potential Projects

• Long-Term Decisions

• Large Expenditures

• Difficult/impossible to reverse

• Determines firm’s strategic direction

Good Decision Criteria

• All cash flows considered?

• TVM considered?

• Risk-adjusted?

• Ability to rank Projects?

• Indicates added value to the firm?

Steps for Capital Budgeting

1. Generate ideas that meet objectives of the company

2. Estimate CFs (inflows & outflows)

3. Asses riskiness of CFs

4. Determine the appropriate cost of capital

5. Find NPV and/or IRR.

6. Accept if NPV>0 and/or IRR>WACC

Capital Budgeting Methods Used

1. Payback

2. NPV

3. IRR

4. Profitability Index (PI)

Net Present Value

How much value is created from undertaking an investment

NPV is a direct measure of how well this project will meet the goal of increasing shareholder wealth

• NPV>0 means: accept project, project is expected to add value to firm, and will increase the wealth of the owners

Meets all desirable criteria

• Considers all CFs

• Considers TVM

• Adjusts for risk

• can rank mutually exclusive projects

• Metric: $

Dominant method: always prevails

Payback Period

How long does it take to recover the initial cost of a project?

• Estimate the cash flows

• Subtract the future cash flows from the initial cost until initial investment is recovered

• A “break-even” type measure

• Metric: Years

Decision Rule: Accept if the payback period is less than some preset limit

Advantages of Payback

• Easy to understand

• Adjusts for uncertainty of later cash flows

• Biased towards liquidity

Disadvantages of Payback Period

• Ignores the time value of money

• Requires an arbitrary cutoff point

• Ignores cash flows beyond the cutoff date

• Biased against long-term projects, such as research and development, and new projects

Internal Rate of Return (IRR)

Independent of interest rates. Based on entirely on the estimated cash flows. Intuitively appealing.

Discount rate that make NPV=0

Decision Rule: accept the project if the IRR is greater than the required return

Metric: %

Most important alternative to NPV

Widely used in practice

Advantage of IRR

Preferred by executives

• Intuitively appealing

• Easy to communicate the value of a project

If the IRR is high enough, may not need to estimate a required return

Considers all cash flows

Considers time value of money

provides indication of Risk

Disadvantages Of IRR

Can produce multiple answers

Cannot rank mutually exclusive projects

Reinvestment assumption flawed

Nonconventional Cash Flows

Cash flow sign changes more than once

Most common:

Initial cost (negative CF)

• a stream of positive CFs

• Negative cash flow to close project

• For ex, nuclear power plant or strip mine

Mutually Exclusive Projects

• Initial investments are substantially different

• Timing of cash flow is substantially different.

• Will not reliably rank projects

“If you accept one project, you cannot accept the other”

Reinvestment Rate Assumption

IRR assumes reinvestment at IRR

NPV assumes reinvestment at the firm’s weighted average cost capital (opportunity cost capital)

• More realistic

• NPV method is Best

Use NPV to choose between mutually exclusive projects

Two Reasons NPV Profiles Cross

Size (scale) differences

• Smaller project frees up funds sooner for investment

• The higher the opportunity cost, the more valuable these funds, so a high discount rate favors small projects

Timing differences

• Project with faster payback provides more CF in early years for reinvestment

• If discount rate is high, early CF especially good

Conflicts between NPV and IRR

NPV directly measures the increase in value to the firm

Whenever there is a conflict between NPV and another decision rule, always use NPV

IRR is unreliable in the following situations:

• Nonconventional cash flows

• Mutually exclusive projects

Profitability Index

Measures the benefit per unit cost, based on the time value of money

• A PI of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value

Can be very useful in situations for capital rationing

Metric: Ratio

Decision Rule: If PI>1 accept the project

Advantages of PI

Closely related to NPV, generally leading to identical decisions

• Considers all CFs

• Considers TVM

Easy to understand and communicate

Useful in capital rationing

Disadvantages of PI

May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

Capital Budgeting Practice

Consider all investment criteria when making decisions

NPV and IRR are the most commonly used primary investment criteria

Payback is a commonly used secondary investment criteria

All provide valuable information

Relevant Cash Flows

Include cash flows that will only occur if the project is accepted

Incremental Cash Flows

Is the increase in cash that the addition of a specific new project generates above the current cash flow

Corporate cash flow with the project —- corporate cash flow without the project

Stand Alone Principle

allows use to analyze each project in isolation from the firm by focusing on incremental cash flows

Sunk Costs

Expenses that have already been incurred, or that will be incurred, regardless of the decision to accept or reject a project

For example, a marketing research study exploring business possibilities in a region would be a ___ cost, since its expenditure has done prior to undertaking the project and will have to be paid whether or not the project is taken.

NOT RELEVANT

Opportunity Costs

Costs that may not be directly observable or obvious, but result from benefits being lost as a result of taking on a project

For Example, if a firm decides to use an idle piece of equipment as part of new business, the value of the equipment as part of a new business, the value of the equipment that could be realized by either selling or leasing it would be releveant

INCLUDE

Synergy Gains

The impulse purchase or sales increases for other existing products related to the introduction of a new product

For example, if a gas station with a convenience store attached, adds a line of fresh donuts and bagels, the sales of coffee and milk, would result in synergy gains

Include

Erosion Costs

• Cost that arise when a new product or service competes with revenue generated by a current product or service offered by a firm

• For ex, if a store offers two types of photo-copying services, a newer, more expensive choice and an older economical one.

• Some of the the revenues from the older repeat customers will be lost and should therefore be accounted for in the incremental cash flows

• Include

Calculation:

Consider the amount of lost contribution margin i.e. (selling price— unit cost) from SSD’s drop in sales

Erosion Cost= (Unit Sales of SSD before launch)— (unit sales after launch) X (selling price - Unit cost)

Changes in Net Working Capital (NWC)

Current Assets—- Current Liabilities

• A INCREASE in net working capital consumes cash

• A DECREASE in net working capital frees up cash

Profit is not cash because of accural accounting

• Revenue is recognized when it’s earned, not when cash is received > creates AR

• Expenses are recognized when they’re incurred, not when cash is paid> creates AP

Operational NWC

(AR + Inventory)— AP

Operating Cash Flow

EBIT + Depreciation— Taxes

Cash Flow From Assets

OCF——Net Capital Spending (NCS)— Changes in NWC= OCF + CFncs + CF NWC

Steps Required for Making capital Investment Decisions (CHP 9)

Step 1: Cash flows Out: Year 0

• Capital Spending

• Working capital

Step 2a: Calculate annual depreciation

Step 2b: Cash Flows IN— Years 1—- end of project— annual operating cash flows (OCF)

Step 3: Cash Flows In: Terminal Year

• After- tax Salvage Value

• Working Capital recapture

Step 4: use cash flows to calculate NPV, IRR, Payback

The Tax Shield Approach to OCF

OCF= EBITDA (1—Tc) + (Depreciation) (Tc)

• EBITDA= Sales—Costs)= EBIT + Depreciation

• Tc= Marginal tax rate

Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield.

Depreciation and Capital Budgeting

Use the schedule required by the IRS for tax purposes

Depreciation is a noncash expense

• Only relevant due to tax effects

Depreciation tax shield= D x Tc

• D= Depreciation expense

• Tc= Marginal tax rate

Straight- Line Depreciation

Spreads the cost evenly over the asset’s useful life

• D= (Initial cost— Salvage)/useful life (years)

same depreciation amount each year; easier to calculate and understand

MACRS Depreciation

An accelerated method used for U.S. tax purposes that allows for larger depreciation deductions in the early years of an asset’s life

Key Features:

• Accelerated: Higher deductions upfront, then decreasing over time

• Depreciate to Zero: Assumes a zero salvage value for tax purposes

• Recovery Period: Assets are assigned to specific “classes” with defined “recovery periods” (e.g. 3 year, 5 year, 7 year property), which is often shorter than the assets actual useful life

After- Tax Salvage Value (ATSV)

When an asset is sold, there are two cash flow events:

• The cash received from the buyer (the Salvage Value)

• The tax impact from the sale ( a tax payment on gain or a tax shield from a loss)

Step 1: Find the Taxable Gain Or Loss

Taxable Gain or Loss= Salvage Value— Book Value

• Salvage Value (SV): The market Price you sell the asset for

• Book Value (BV): the assets’s value on your balance sheet

  • BV= Initial cost—- Accumulated Depreciation

Step 2: Calculate the Tax Impact (use marginal tax rate Tc)

Scenario A: Gain ( SV> BV)

• Selling Price> Book value

• You must pay taxes on profit

• Tax impact= Taxes Paid ( a cash outflow)

• Taxes Paid= T (SV-BV)

Scenario B: Loss (SV < BV)

• Selling Price < Book Value

• This loss creates a tax shield (a tax saving)

• Tax Impact= Tax Shield (a cash inflow)

• Tax Shield= T (SV-BV)

Step 3: Find the Total After-Tax Salvage Value

• If you had a GAIN:

  • ATSV= Salvage Value — Taxes Paid on Gain

  • = Salvage Value — (Tax rate* taxable Gain)

• If you had Loss:

  • ATSV= Salvage Value — Taxes Paid on Loss

    • =Salvage Value — (Tax rate * Taxable Loss)

    • The taxable loss is negative

Forecasting Risk

Sensitivity of NPV to changes in cash flow estimates

• The more sensitive, the greater the forecasting risk

Scenario Analysis

Examines several possible situations

• Worst Case

• Base case or most likely case

• Best case

Provides a range of possible outcomes

Problems with Scenario Analysis

• Considers only a few possible outcomes

• Assumes perfectly correlated inputs

• All “bad” values occur together and all “good” values occur together

• Focuses on stand-alone risk, although subjective adjustments can be made

• No Decision Rule

• Ignores Diversification

Sensitivity Analysis

Shows how changes in an input variable affect NPV or IRR each variable is fixed except one.

Strengths:

• Provides indication of stand-alone risk

• Identifies dangerous variables

• Gives some breakeven information

Weaknesses:

• Does not reflect diversification

• Says nothing about the likelihood of change in a variable

• Ignores relationships among variables.

• No Decision Rule

• Ignores Diversification

Managerial Options

Contingency Planning

Option to Expand:

• Expansion of Existing Product Line

• New Products

• New geographic markets

Option to abandon

• Contraction

• Temporary suspension

Option to Wait

• Strategic Options

Capital Rationing

Occurs when a firm or division has limited resources

• Soft: the limited resources are temporary, often self-imposed

• Hard: capital will never be available for this project

The PI is useful tool when faced with soft rationing

Weighed Average Cost Capital

WACC= WcRs + WpRp + WdRd( 1 -- T)

• Wc= weight of common equity

• Wp= weight of preferred stock

• Wd= weight of debt.

  • These represent the proportion of financing coming from each source in the firm’s capital structure. All weights together add up to 1

• Rs= cost of common equity

• Rp= cost of preferred stock

• rd= cost of debt

  • These represent the required return investors demand for each financing source. Interest rate paid on loans/bonds.

Minimum acceptable rate of return the firm should earn on its investments of average risk in order to be profitable

= discount rate for computing NPV

IRR> WACC for acceptance of project

Cost of Capital Basics

The cost to a firm for capital funding

= the return to the providers of those funds

• The return earned on assets depends on the risk of those assets

• A firm’s cost of capital indicates how the market views the risk of the firm’s assets

• A firm must earn at least the required return to compensate investors for the financing they have provided

• The required return is the same as the appropriate discount rate

Cost of Equity: Rs

Return required by equity investors given the risk of the cash flows from the firm

• Firm’s perspective: minimum return it must earn on new equity financed projects to keep its stock price stable

• Investor’s perspective: expected return on the company’s stock, given its risk.

Two major methods for determining the cost of Equity

• Dividend Growth Model

  • Re= D1/Po + G

• SML Or CAPM

Advantages and Disadvantages of the Dividend Growth Model

ADV: Easy to understand

Disadvantages:

• Only applicable to companies currently paying dividends

• Not applicable if dividends aren’t growing at a reasonably constant rate

• Extremely sensitive to the estimated growth rate

• Does not explicitly consider risk

The SML Approach

Security Market Line

Re= Rf + Be (E(Rm) - Rf)

• Rf: risk-free rate

• (E(Rm) - Rf): Market risk premium

• B: systematic risk of asset

Advantages of SML

• Explicitly adjusts for systematic risk

• Applicable to all companies, as long as beta is available

Disadvantages of SML

• Must estimate the expected market risk premium, which does vary over time

• Must estimate beta, which also varies over time

• Relies on the past to predict the future, which is not always reliable.

Cost of Debt: Rd

The required return on a company’s debt

1. Method 1: compute the Yield to Maturity (YTM)

2. Method 2: use estimates of current rates based on the bond rating expected on new debt

The cost of debt is NOT the coupon rate

After Tax Cost of Debt

= Rd, bt (1 - Tc)

Cost of Preferred Stock Rp

Preferred pays a constant dividend each period

Dividends expected to be paid forever

P/S is a perpetuity

Rp= D/Po

Determining the Weights for the WACC

weights= percentages of the firm that will be financed by each component

Always use target weights, if possible.

• If not available, use market value

Capital Structure Weights

• E: Market value of equity

  • number of outstanding shares times price per share

• D: Market Value od Debt

  • number of outstanding bonds times bond price

• V: Market value of the firm= D + E

• E/V: % financed with equity= wc

• D/V: % financed with debt= wd

Factors that Influence a Company’s WACC

Market conditions, especially interest rates, tax rates, and the market risk premium

The firm’s capital structure and dividend policy

The firm’s investment policy

Firm’s with riskier projects generally have a higher WACC

Pure Play Approach

Find one or more companies that specialize in the product or service being considered

Compute the beta for each company

Take an average

Use that beat along with the CAPM to find the appropriate return for a project of that risk

Pure play companies can be difficult to find

Subjective Approach

Consider the project’s risk relative to the firm overall

• If the project is risker than the firm, use a discount rate greater than the WACC

• If the project is less risky than the firm, use a discount less than WACC

Risk-Return Trade-Off

Two key lessons from capital market history:

• There is a reward for bearing risk

• The greater the potential reward, the greater risk

Total Dollar Return

Return on an investment measured in dollars

• Dollar return= Dividends + Capital gains

• Capital gains= Price received — Price paid

Total Percent Return

the return on an investment measured as a percentage of the original investment

• Percent return= dollar return/dollar invested

Linear Scale

Linear Axis: equal vertical distance = equal absolute change ($)

Shows absolute dollar change. This scale can be misleading, as it makes recent volatility look enormous and early growth insignifcant

Logarithmic Scale

Log Axis: equal vertical distance= equal percentage change (%)

Shows rate of change (percentage). Each vertical step represents a consistent percentage gain (e.g. a 100% return). A straight line on a long chart implies constant compound growth.

Conclusion: A log scale is the standard for visualizing long-term, compounding investment performance as it accurately reprents growth rates over time.