Capital budgeting

Question 1

What are we going to do today?

Answer 1

We will dicuss the investment decision criteria

Question 2

What is capital budgeting again?

Answer 2

One of the 3 decisions in which firms make, and it is what long term investments should a firm make, its also known as investment apprasial.

Question 3

What are the 3 investment decisions criteria we wil talk about?

Answer 3

Net present value

The internal rate of return

The payback rule

Question 4

When a firm has a project, ie to enter a new line of business, whether to start producing a new product or invest in equipment to reduce costs, what do you have to do?

Answer 4

They make a decision on whether the project is financially viable or not.

Question 5

What did we say in the last lecture firms want to do for their business?

Answer 5

Increase shareholders wealth.

Question 6

What is Net present value as a way for decision making?

Answer 6

What is the value today of all these streams of cash flows that will occur in the firm as a consequence of this project.

Bascially the difference between the revenue of firm and costs

So the company is discounting all the future cash flows.

Question 7

So how do we calculate discouting cash flow valuation?

Answer 7

The initial NPV is negative, because cash outflow > cash inflow, e.g investing in machines.

Question 8

Workout NPV by finding PV and culumative PV?

Answer 8

Question 9

As 20 is postiive, what does it mean for the deciison of the firm?

Answer 9

It is positive so they should accept the project as it adds value to the firm.

Question 10

Just as a reminder what do we always assume about cash flows ?

Answer 10

Its given at the end of the period

Question 11

So what is the net present value criteria?

Answer 11

When NPV is greater than 0, we accept the project

When NPV is less than 0, we dont accept the project

Question 12

What happens when NPV = 0?

Answer 12

Thats the breakeven point, meaning your indifferent on accepting the project or not.

Question 13

If your choosing among several projects, what do you do?

Answer 13

Pick the one with the highest NPV

Question 14

So what is the main object about NPV?

Answer 14

Maxmising shareholders wealth

Question 15

What is a key determinant when calculating NPV?

Answer 15

The discount rate which is called the opportunity cost of capital ( a higher discount rate means lower NPV.

Question 16

So there is an inverse relationship between what?

Answer 16

Discount rate and NPV

Question 17

Dont copy the method thats used here, use your own method, by listing the years, PV and Culumative PV and remember year 0 = -10000?

Answer 17

Question 18

Do not follow the method shown, do your method of when year 0 = -30000 and there are 8 years, after of constant cash flows?

Answer 18

Rememeber timeline.

the exam here uses the annuity formula.

Question 19

What are strengths of NPV?

Answer 19

Uses all cash flows ( other approaches ignore cash flows beyond a certain date)

Represents the additional value to shareholders. ( so you can do comparisons

Fully incorporates time value of money.

Question 20

What is the internal rate of return?

Answer 20

It is the discount rate in the NPV formula that makes the NPV equal 0 ( if you want to be indifferent in taking the project or not, what would be the discount rate)

Question 21

So how do we solve for the internal rate of return?

Answer 21

We have to first assume NPV = 0 and then solve for IRR in the dominator, then this will give the internal rate of return.

Question 22

So how do we calculate IRR properly?

Answer 22

TBA

Question 23

So when we find the internal rate of return, how do we use that for decision making?

Answer 23

lets say IRR = 11.04% Do i accept the project?

First of all you need to calculate the opportunity cost of capital ( my required rate of return, given riskness of the project)

e.g. if i = 12% and IR = 11.04% reject as IRR is smaller.

So find IRR, compare to required rate of return

Question 24

So what is the decision rule for IRR?

Answer 24

If IRR> Required rate of return it means NPV is positive

If IRR< Required rate of return it means that NPV is negative.

Question 25

Answer 25

Question 26

Answer 26

Question 27

What is the first problem with IRR?

Answer 27

If your cash flows are non convential ie change of sign more than once, finding IRR will lead to multiple solutions, thus you do not have a unique solution.

Question 28

What is the maximum amount of IRR you can get with non convential cash flows?

Answer 28

The maximum number of IRRs that there can be is equal to the number of times that the cash flows change sign from positive to negative and/or negative to positive

Question 29

What is a second problem with IRR?

Answer 29

Lets say you have 2 mutually exclusive projects 1 skyscraper and land, when you calculate IRR you might see one as bigger than the other and think,that the biggest IR is the right decisions, but we need to compare to the Required rate of return, then make a decision, as we want to maxmise shareholders wealth.

Question 30

Does IRR take into account the scale of the project?

Answer 30

Nope ( lets say you have the shard and a car park and both have a IRR = 8%, but a car park will give a relatively small rate of return compared to the shard)

Question 31

What are 2 advantages of IRR?

Answer 31

Closely related to NPV, often leading to identical decisisons

Easy to understand and communicate

Question 32

What is the payback rule?

Answer 32

In how long ( time) do we get back the inital investment we put in the project

So it is the project life resulting in NPV = 0

Question 33

For the decision rule of Payback, what do we need?

Answer 33

A benchmark

Question 34

So what is the decision rule for the payback period method?

Answer 34

You accept if the payback period is less than benchmark

You decline if the payback period is more than the benchmark.

Question 35

What is the payback period?

Answer 35

Initial investment = 50000

Year 1 = 30000

Year 2 = 20000

Payback period = 2 and you compare to the benchmark.

Question 36

Lets say you have a payback period between 2 years how do you work it out?

Answer 36

Payback inbetween 2 and 3

Question 37

Answer 37

A: 2.6 years

B: never

C: 4 years

D: 2 years and 4 years

E: 6 months

You can see problems in d as you have more investments in year 3

Question 38

So we have looked at decisions rules for capital budgeting but what willl we do now?

Answer 38

How we get our estimated cash flows ( how we get our future revenues and costs)

In other words the numerator of the NPV formula

Question 39

What are Project cash flows?

Answer 39

Project OCF (Operating cash flows) + Project CAPEX ( capital expenditure as a cash flow e.g. machinery = Project cash flow

Question 40

What are operating cash flows?

Answer 40

Revenue ( from sales) - Fixed + variable costs of production

Question 41

What are 3 other things we must deduct from Operating cash flows?

Answer 41

1) Taxes we pay
2) the effect of depreciation
3) the changes in working capitals that generates relevant cash flows

Question 42

So how do we work out the taxes, to dedcut?

Answer 42

The company needs to pay taxes, a cash outflow If tax rate is 23%, (revenues – costs) net of taxes is : (Sales – Total Costs)*(1 ‐ 0.23)

So revenue minus costs X ( 1-t)

Question 43

In this course when talking about depreciation we only talk about what?

Answer 43

Straight line depreciation, depreciation gives tax benefits thats why its important to deal with this.

Question 44

Calculate tax benefit from depreciation and what do we do with this

Answer 44

We add the shielded tax amount back to the operating cash flows

Question 45

What is working capital and what happens at the end of a project?

Answer 45

Inventory

Trade receivables

Trade payables

( these are short term assets and liabilities companies need to operate)

At the end of a project, the sum of the changes in working capital is zero (i.e. everything recovered, everything paid for by customers or paid to suppliers, remaining inventories sold)

Question 46

Caluclate the change in the working capitals

Answer 46

Same as cash flow reasonings

Question 47

Example of Net Working Capital calculations over three periods Suppose that in addition to an initial Working Capital of 100 in Year 0, the stock of NWC is kept at 10% of sales at the end of every subsequent year, calculate change in stock from the previous year and what would be the effect on cash flows. Then year 3 we have to recover all the remaining working capital, so what do we do?

Answer 47

In year 3 we need to add 100 ( but this has to be discounted at time 3 remember)

Question 48

So again to summarise what is the operating cash flows for the firm ( the numerator of NPV) ?

Answer 48

Question 49

What is EBIT, Net income and total taxes?

Answer 49

Question 50

What are the relevant cash flows we need for projects?

Answer 50

The incuremental cash flows for project evaluation consisit of all and any cash flow that are a direct consequence of undertaking the project.

So we like at the side effects of what the company is doing.

Question 51

For example: a proposed project will generate £10,000 in revenue, but causes another product line to lose £3,000 in revenues.What is the incrumental cash flow?

Answer 51

Its £7000 because by undertaking this project we affect, what the company is already doing.

Question 52

What is a vital cash flow we must include which are relevant?

Answer 52

Opportunity cost : Cost of a resource that affects the project even if it has no cash flow, the most valuable alternative that is given up if the project is undertaken.

• For example: the project may use a piece of land the firm already owns. the opportunity cost is how much that land could of been sold. (opportunity cost of land) should be included

Question 53

What are 2 examples of costs that shouldnt be included in cash flows?

Answer 53

Financing costs ( Dividends and interest)

Sunk costs ( costs that have already been incurred and cannot be removed e.g. lets say you higher a consultant, that gives advice for project, he or she still needs to be paid, whether or not the project goes ahead or not)

Question 54

Lets look at cost reduction projects, which are mututally exclusive( you choose one of the other) and have different lives

Suppose that you have to choose between two mutually exclusive production methods, producing exactly the same good, with same capacity and same revenue, but with different costs and different lives: Machine A: costs £15,000, costs £5,000 per year to run and lasts 5 years • Machine B: costs £10,000, costs £6,000 per year to run and lasts 3 years

What is the PV, with discount rate of 6

Answer 54

We think that becasue second is cheaper and we are trying to reduce cost this makes sense but thats false, as they both have different lives

Question 55

So we know we cant compare PV because they have different lives, so what are 2 possibilities?

Answer 55

1) Equal the lives and compare NPV of the projects, so for project A repeat it 3 times and b repeat it 5 times this is not really pratical so we use
2) Equivalent annual cost ( EAC)

Question 56

What is the equivalent annual cost?

Answer 56

the present value of a project’s total costs calculated on an annual basis.

Calculate PV of all costs

• Using annuity formula, calculate the annualised capital cost (the annuity payment) that would generate that PV

Question 57

So how would we use Equivalent annual cost to compare using annuity formula ?

Answer 57

We know from last week PV = C x Annuity factor

So now solve for C = Pv/ annuity factor

We pick machine A