Unit 9: Capital Budgeting Process

Question 1

Stages of Capital Budgeting

(Identify

Search

Inform

Select

Finance

Implement and Monitor)

Answer 1

• 1. Identification and definition
  
  • This stage is the most difficult.
• 2. Search (screening)
  
  • Potential investments are subjected to a preliminary evaluation by representatives from each function in the entity’s value chain.
• 3.Information-acquisition (cost and benefit assessment)
  
  • Quant fin measures are given the most scrutiny
    
    • Initial investment and period cash inflow
  • Nonfinancial measures, both quant and quali, are identified and addressed
    
    • Need for additional training or higher customer satisfaction based on improved product quality
    • Also, uncertainty about tech developments, demand, competitors, government regulation, and economic conditions should be considered.
• 4.Selection.
  
  • Employing one of the selection models (net present value, IRR, etc) and relevant nonfinancial measures, the project will increase shareholder value by the greatest margin are chosen for implementation.
• 5. Financing. Sources of funds for selected projects are identified. These can come from company’s operations, issuance of debt or the sale of company stock.
• 6. Implementation and monitoring. Once projects are underway, they must be kept on schedule and within budgetary constraints.

Question 2

Steps in Ranking Potential Investment

Answer 2

• 1. Determine the asset cost or net investment
  
  • Net outlay or gross cash requirement, minus cash recovered from the trade or sale of existing assets, with any adjustments for tax consequences.
  • Moreover, the investment required includes funds to provide for increases in net working capital, for example, the additional receivables and inventories resulting from the acquisition of a new manufacturing plant.
    
    • This change in net working capital is TREATED AS AN INITIAL CASH OUTFLOW THAT WILL BE RECOVERED AT THE END OF THE PROJECT.
• 2. Calculate estimated cashflows
  
  • Reliable estimates of cost savings or revenues are necessary.
  • Net cash flow is the economic benefit or cost, period by period, resulting from the investment.
  • Economic life is the time period over which the benefits of the investment are expected to be obtained.
  • Depreciable life is the period for account and tax purposes. AND GIVES RISE TO A DEPRECIATION TAX SHIELD.
• 3. Relate the cash-flow benefits to their cost.
• 4. Rank the investments
  
  • A firm’s hurdle rate is the minimum return on a project or investment that an investor is willing to accept.
    
    • The riskier the higher.
    • He lower the firms discount rate, the lower the acceptable hurdle rate.
    • A common is linked to rejection of problems that should be accepted (this is why is better to use the dollar version of the ROI).

Question 3

Relevant time spams and items for Cash Flow Calculation

(Net initial investment

Annual net cash flows

Project Termination Cashflows)

Attention to after Tax from disposals of old and new equipment

Answer 3

• Net initial investments:
  
  • ​1.Cost of new equipment
  • 2. Initial working capital requirements (recovered at the end)
  • 3. After-tax proceeds from disposals of old equipment

OPERATING COSTS OF OLD EQUIPMENT MATTER BUT THE ORIGINAL COST OR FAIR VALUE OF OLD DOESN’T BECAUSE IS A SUNK COST

Tax gain or loss is determined

A = Disposal value – tax basis (CHECK WHEN TAX HAS TO BE PAID, IF IN THE END YOU HAVE TO BRING IT AT PRESENT VALUE)

The after-tax effect on cash can then be calculated

Disposal value – A * tax rate

• Annual net cash flows
  
  • 1. After tax collections from operations (excluding D&A)
  • 2. Tax savings from depreciation deductions from new project (D&A tax shield)
    
    • On the exam, salvage value is never subtracted when calculating depreciable base because this is a provision allowed by US tax laws.
• Project termination cash flows
  
  • 1. After-tax proceeds from disposal of new equipment
    
    • Tax gain or loss is determined

A = Disposal value – tax basis ((CHECK WHEN TAX HAS TO BE PAID, IF IN THE END YOU HAVE TO BRING IT AT PRESENT VALUE)

    * ***The after-tax effect on cash can then be calculated***

Disposal value – A * tax rate

* **Recovery of working capital (untaxed)**

Question 4

Overall Framework for Calculations

Answer 4

>>>>> periods

1. Sales - cash outlays = annual cash outflows
2. After-tax cash flow = Net annual cash outflows minus income taxes.
3. Net after tax cash flow = After tax annual cash outflow - depreciation and terminagtion salvage value
4. PV of 3.

Question 5

Types of Risk Analysis

Answer 5

• Risk analysis measures the likelihood of the variability of future returns from the propose capital investment. Techniques:
  
  • Informal method. NPVs are calculated at the firm’s desired rate of return, and the possible projects are individually reviewed. If NPVs are similar, less risky project is chosen.
  • Risk Adjusted discount rates. The discount rate of a capital is generally the company’s cost of capital.
    
    • Thus, discount rates may vary among capital investments depending on the company’s cost of capital and the type of investment.
    • Some investment may be accepted (rejected) with the internal rates of return (IRR) that are les than (greater than) the company’s cost of capital.
  • Certainty equivalent adjustments. Indifference between sum of money and expected value of a risky sum. Not popular.
  • Simulation analysis. Computer based scenarios for exceptionally large and expensive projects.
  • Sensitivity analysis. Forecasts of many calculated NPVs under various assumptions to see sensitivity to changing conditions.
  • Scenario analysis. The profitability of a capital investment is analyzed under various economic scenarios.

NOTICE THE DIFFERENCE BETWEEN SENSITIVITY (ASSUMPTIONS) VS SCENARIO (ECONOMIC ENVIRONMENT)

• Monte Carlo Simulation
  
  • Used to generate the probability distribution of all possible outcomes from a capital investment. Independent variables are randomly chosen based on the probability dx of each one.

Question 6

Real Options

Answer 6

Real options are options to modify the capital investment

• Real Options
  
  • Decision three analysis with recognition of probabilities and outcomes and simulations.
  • Types of real options:
    
    • Abandonment: entails selling assets or employing them in an alternative project. If NPV of abandonment is > than NPV of future cashflows then abandon.
    • Delay
    • Expand : allows for expansion with little or low cost.
    • Scale back (opposite of above)
    • Vary inputs like substitute fuels
    • Vary output to respond to economic condition
    • To enter a new market
    • New product option sell complementary or next generation product even though the initial product is unprofitable.
  • Qualitative considerations
    
    • The option is more variable the later is exercised, the more variable the underlying risk, or higher the level of interest rates.

Question 7

Ordinary vs Annuity Due

Answer 7

• Ordinary annuity (annuity in arrears) - ORDINARY = INTUITIVE = STATUS QUO (END) is a series of payment occurring at the end of each period
  
  • First payment is discounted
  • Interest is not earned for the first period.
• Annuity due (annuity in advance) is a series of payment occurring at the beginning of each period.
  
  • First payment is not discounted
  • Interest is earned on the first payment of annuity due.

Question 8

NPV and/vs IRR

Answer 8

• NPV
  
  • NPV nets cash flows (inflows and outflows) related to a project, then discounts them at the hurdle rate (also called desired rate of return).
    
    • IF NPV IS POSITIVE THE PROJECT IS DESIRABLE BECAUSE IT HAS A HIGHER RATE OF RETURN THAN THE COMPANY’S DESIRED RATE.
• IRR
  
  • The internal rate of return expresses projects return in percentage terms
    
    • The IRR is the discount rate at which the investment’s NPV equals zero.
    • If IRR is higher than company’s desired rate of return, then the investment is desirable. (THIS WOULD BE TRUE TO NPV TOO UNDER CERTAIN CONDITIONS)

IF REQUIRED RATE OF RETURN IS EQUAL TO IRR BOTH METHODS YIELD THE SAME DECISION.

• Disadvantages of IRR
  
  • Direction of cash flows: when the direction of cash flows changes, focusing simply on IRR can be misleading.
    
    • Projects can have the same IRR but one can have a better NPV.
  • Mutually exclusive projects
  • Varying rates of return
    
    • IRR is limited to a single summary rate for the entire period.
  • Multiple investments
    
    • NPV amounts from different projects can be added but IRR rates cannot.

Question 9

• Comparing cash flow patterns

Answer 9

• Often a decision maker has to choose between two mutually exclusive projects, one whose inflows are higher in the early years then they fall, and other whose inflows are steady
  
  • The higher the firm’s hurdle rate, the more quickly a project must pay off (since it discounts more strongly future cash flows of long term projects)
  • Firms with low hurdle rates prefer a slow and steady payback.

Question 10

Comparing NPV and IRR

(superiority of NPV)

(NPV assumes that all projects are discounted at the projects discounted rate or cost of capital while NPV assumes that all projects will be reinvested according to IRR)

Answer 10

• The reinvestment rate becomes critical when choosing between NPV and IRR methods.
  
  • NPV assumes that the cash flows from the investment can be reinvested at the projects discount rate.
• The NPV and IRR methods give the SAME accept/reject decision if projects are independent (unrelated cashflows).
• If one of two or more mutually exclusive project is accepted, then the others must be rejected.
  
  • NPV and IRR methods may rank mutually exclusive projects differently if
    
    • The cost of one project is greater than the cost of other
    • The timing, amounts and directions of cash flows differ among projects
    • Projects have different useful lives
    • The cost of capital or desired rate of return varies over the life of ta project
    • Multiple investments are involved in a project (addability of NPV method).
  • The IRR method assumes that cashflows will be reinvested at the internal rate of return, therefore NPV does a better job considering the desired rate of return (since is more realistic)
• THE MANAGER CONCERNED WITH SHAREHOLDER MAXIMIZATION SHOULD CHOOSE THE PROJECT WITH THE GREATES NPV, NOT THE LARGEST IRR (IRR IS A % MEASURE OF WEALTH, BUT NPV IS ABSOLUTE)
  *

Question 11

Payback Methods (Normal and Discounted)

• Method of calculation
• Advantages and disadvantages
• Payback reciprocal

Answer 11

• Payback period is the number of years required to return the original investment
  
  • Formula (IF CASHFLOWS ARE CONSTANT): INITIAL NET INVESTMENT/ANNUAL EXPECTED CASH FLOW
  • IF Cash flow are not constant, calculation must be in cumulative form, excluding the inflows from initial investment until it reaches the payback period (initial investment is netted off)
  • Advantage:
    
    • Is simple and indicates a rough form of a project’s liquidity. The longer the period, the less liquid the investment.
  • Disadvantage
    
    • Disregards all cash inflows after the payback cutoff date
    • Disregards time value of money.
  • Discounted payback method (ALSO CALLED BREAKEVEN)
    
    • Acknowledges time value of money, and you should exclude the discounted net cash inflows from initial investment.
    • Disadvantage: still ignores future cash inflows after the cut-off date.
    • Can be used to calculate breakeven time: when discounted cumulative cash inflows on a project quals the discounted cumulative cash outflow (USUALLY bit not always the initial cost)
  • Bailout payback method: incorporates the savage value of the asset in the calculation. Measures the length of payback period when the periodic cash inflows are combined with the salvage value (at end).
  • Payback reciprocal: = (1/Payback period) and approximates the INTERNAL RATE OF RETURN.

Question 12

Profitability Index

Answer 12

• Profitability Index (OR excess present value index) – AIMING TO RETURN HIGHER NPV PER DOLLAR INVESTED (EFFICIENCY NOT EFFICACY)
  
  • ​FORMULA = PV OF FUTURE CASHLOWS / NET INVESTMENt
  • Bigger than 1, then yes ACCEPT IT. IRR is bigger than required rate of return. AND VICE VERSA.
    
    • Numerator can be:
      
      • Net present value of all cash flows, then index will be smaller than 1.
      • Net present value only of cash inflows (more traditional/check questions since appear to have preference – 9.5 from page 21), then the index will be bigger than 1.
        
        • These two don’t invalidate the fact that the higher the index the better (THIS IS ABOUT RANKING NOT SCREENING)
    • RECOMMENDED TECHNIQUE FOR EVALUATING PROJECTS WHEN CAPITAL IS RATIONED AND THERE ARE NO MUTUALLY EXCLUSIVE PROJECTS.
    • NPV Method and Profitability Index result in the same project selection ( DOESN’T MEAN THE RANKING IS THE SAME).