L4 Refined Corporate finance: Capital budgeting

Investment decision rules on how to evaluate if a project should be accepted or rejected.

The NPV rule:

It measures exactly how much wealth a project creates after discounting future cash (giving us the present value) and help decide whether to invest or not.

-        Most reliable one and accurate one.

-        Stand-alone project: Accept the project if NPV > 0.

-        If you choose between multiple projects, pick the one with the highest NPV.

-        Calculated: (Current value of all future cash flows) minus (the initial cost today).

-        As the discount rate (r) rises, NPV generally goes down; riskier projects require a higher discount rate.

The Internal Rate of Return (IRR) Rule:

The IRR is the break-even discount rate that makes the NPV equal to zero. It represents the average annual percentage growth/return on an investment. The higher IRR, the better investment. Identifies how much the NPV changes based on capital cost variations.

-        Rule: Accept a project if the IRR is greater than the opportunity cost of capital.

IRR can be misleading in 3 cases:

-        Delayed Investments (1): If positive cash flows occur before expenses, the IRR can suggest acceptance even when the NPV is negative. NPV will be n increasing function of r.

-        Multiple (2) or Nonexistent IRRs (3): Some projects may have multiple IRRs that set the NPV to zero, or no IRR may exist at all.

The Payback Rule:

This rule accepts projects if they recover their initial investment within a prespecified period.

-        It is applied by calculating the amount of time it takes to pay back the initial investment, known as the payback period.

-        Then compare to a prespecified length of time.

-        Only accept if the payback period is shorter.

Payback rule pitfalls:

-        Ignores Time Value of Money (TVM): The method treats cash inflows received in the future the same as money in hand today, failing to discount them to their present value, which violates core financial principles.

-        Ignores Future Cash Flow: A project that pays back quickly but generates no profit afterward might be chosen over a slower, but much more profitable, long-term project.

-        Arbitrary Cutoff (Ad Hoc): There is no objective, scientific basis for deciding what payback period is "acceptable" (e.g., why 3 years instead of 4?).

How to choose between multiple projects:

-        Picking one with highest NPV since it is expressed in present value will lead to high wealth.

-        Instead use Incremental IRR to compare the benefits between multiple projects, comparing what is gained by choosing a more expensive investment over a cheap. But have same pitfalls as IRR.

IRR cannot be used when choosing between multiple projects beacuse of their differences in:

-        Picking one with highest NPV since it is expressed in present value will lead to high wealth.

-        IRR cannot be used due to differences in:

•       Scale (500% on $1, or 20% on $1 million)

•       Timing (500% for one year, or 50% for 20 years)

•       Risk (10% risk-free or 10% high risk)

-        Instead use Incremental IRR to compare the benefits between multiple projects, comparing what is gained by choosing a more expensive investment over a cheap. But have same pitfalls as IRR.

Resource constrains:

Firms cannot take on every positive-NPV project due to the projects being mutually exclusive or because of resource constraints like a lack of funds, land, production capacity, or employees. Due to this the goal is to maximize NPV while staying within the budget.

Profitability index:

Measures how efficiently we use our budget. In these cases, managers use the Profitability Index (PI) to get the "bang for the buck". Calculated as NPV/resource consumed.

Profitability index: Strategy and pitfalls:

-        Strategy: Rank according to the Profitability Index and then accept the top ones until your resource is consumed.

-        Pitfalls: This is only fully reliable if the chosen projects completely exhaust the resource and there is only a single constraint

Capital budgeting:

Process of evaluating and selecting long-term projects.

Capital budgeting is needed because:

-        Investments are big and hard to reverse if wrong decisions are made.

-        Investments generate cash flows arrive over many years (time value of money matters – NPV show that cash today is worth more than future cash)

-        Forecasts are uncertain (using capital budgeting we can test assumptions with sensitivity/scenarios)

-        Resources are limited, so we must rank and choose projects

Capital Budgeting: Selecting a project follows these steps:

1. Forecast incremental earnings (revenues, costs, depreciation, taxes)

2. Convert to free cash flow (FCF) (add back depreciation, subtract CapEx and ΔNWC).

3. Discount FCF to compute NPV.

4. Comparing and analyzing projects: Focus on what changes NPV.

1. Forecast incremental earnings (revenues, costs, depreciation, taxes)

1)     Additional accounting profit generated by the project that we aim to forecast.

-        Incremental Earnings = Unlevered net income = (New sales − New costs − Depreciation) × (1 − tax rate).

• We start with incremental earnings because it’s easy and tax-relevant, then convert it into free cash flow because NPV needs actual cash, not accounting profit.

What to include in the incremental earnings are:

•       extra revenues

•       extra operating costs

•       extra depreciation from new assets (Many different methods, we’ll focus on straight-line depreciation)

•       Indirect effects side effects like cannibalization (competition between your products) (lost sales of old product)

What to exclude:

-        Sunk costs (already spent): Unrecoverable costs that have been (or will be) paid regardless of the decision about whether or not to proceed with the project e.g. fixed overhead expenses, past R&D expenditues and unavoidable competitive effects.

-        Financing costs like interest (handled in discount rate / cost of capital, we want to evaluate the project separate from the financing decision)

Indirect Effects on earnings include:

-        Opportunity Costs: is the value a resource could have provided in its best alternative use

-        Project Externalities: indirect effects of the project that may increase/decrease the profits of other business activities of the firm. This includes when sales of a new product displace sales of an existing product, known as cannibalization (Switch vs Wii U).

2. Convert to free cash flow (FCF) and adjusrtments: (add back depreciation, subtract CapEx and ΔNWC).

1)     Because NPV is based on actual cash rather than accounting profit, earnings must be adjusted. It forms the base for calculating the projects free cash flow, the incremental effect of a project on the firm’s available cash.

 Adjustments: Depreciation is added back because it is a non-cash expense. Capital Expenditures (CapEx) and changes in Net Working Capital (ΔNWC) are subtracted as they represent actual cash outflows

3. Discount FCF to compute NPV:

The free cash flows are discounted back to the present using the project's specific cost of capital.

Comparing and analyzing projects: Focus on what changes NPV:

-        Choose the option with the highest NPV (value created today)

-        When comparing alternatives, focus on incremental cash flows (what differs)

-        The calculation is easy; the hard part is assumptions (price, volume, costs, risk)

-        Stress-test assumptions: Since forecasts are uncertain, managers use three primary analyses to test their NPV: (break-even, sensitivity, scenario analysis)

Break-even, sensitivity, scenario analysis

-        Break-even Analysis: Finding the specific value of one input (like price or units) that results in an NPV of zero.

-        Sensitivity Analysis: Changing one input at a time to see which assumption has the greatest impact on the NPV.

-        Scenario Analysis: Changing multiple parameters simultaneously to evaluate the project's performance under different conditions (e.g., best-case vs. worst-case).