Corporate Finance: Capital Budgeting

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Corporate FinanceCapital Budgeting

• Professor Scott Hoover
• Management 221

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• The Importance of Capital Budgeting
• definition A capital budget is a long-term
  plan that describes the use of long-term assets
  (capital) and details expected future cash
  inflows and outflows (budget).
• How are projects created?
• someone identifies a potential market
• marketing personnel determine the market size
  (sales projections, etc.)
• engineers, cost accountants, and management
  personnel estimate production costs
• finance personnel take projected costs and
  revenues and decide whether or not to accept the
  project

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• verify that the projected cash flows are all the
  incremental cash flows for the project
• incremental cash flows include any impacts that
  the project may have on firm cash flows
• identify cost of capital
• calculate NPV, IRR
• decide whether or not to accept the project.
• finance personnel acquire financing for the
  project
• issue securities (stock, bonds, preferred stock)
  if necessary

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• Project Evaluation Techniques
• Net Present Value (NPV)
• NPV ? the present value of all cash flows
  (including the initial investment) evaluated at
  the company's cost of capital.
• We will define cost of capital in more detail
  later. For now, think of it as the interest rate
  desired by company investors.
• Example A firm is considering a project with
  projected cash flows as follows.
• Should the project be accepted?

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• Suppose that the firm has a cost of capital of
  10. The NPV of the project is calculated as
  followsNPV - 100,000 20,000/1.1
  25,000/1.12 30,000/1.13
  35,000/1.14 35,000/1.15 7,020
• The NPV rule Companies should accept any and
  all projects that have positive NPVs and should
  reject any and all projects that have negative
  NPVs.
• Intuition If the NPV is positive, then the
  project is expected to pay more than enough money
  to give investors the return they desire.
• Internal Rate of Return (IRR)
• IRR ? the implied interest rate on the project.
  Said differently, the IRR is the interest rate
  that makes the NPV equal to zero.

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• NPV 0 - 100,000 20,000/(1IRR)
  25,000/(1IRR)2 30,000/(1IRR)3
  35,000/(1IRR)4 35,000/(1IRR)5
• Solving for the IRR (by trial and error or
  financial calculator) gives IRR 12.4534
• The IRR rule If a company's cost of capital is
  lower than the IRR, then the company should
  accept the project. If the cost of capital is
  higher than the IRR, then the project should be
  rejected.
• Note This rule may not work if the project has
  unusual cash flows. For example, if the sign (
  or -) of the expected cash flows changes more
  than once, there may be more than one IRR. In
  our example, there is one sign change, so there
  can only be one IRR.
• In our example, the firm has a cost of capital of
  10. The project should be accepted because the
  project will create more profits than are needed
  to pay interest on the borrowing.

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• Note that the NPV Rule and the IRR Rule are
  consistent as long as we have typical cash flow
  structures.
• To see this, consider the following.
• We accept the project if and only if the cost of
  capital is below the IRR. Notice that this
  region corresponds to NPVgt0.

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• Example Suppose that two projects are mutually
  exclusive. This means that the firm may choose
  only one of the two projects. The expected cash
  flows are as follows.
• If the cost of borrowing is 10, which project
  should be chosen?
• NPVA -100,000,000 111,100,000 / 1.1
  1,000,000
• NPVB -1,000,000 2,200,000 / 1.1 999,999
• The NPV of Project A is higher, so we should take
  it
• or should we?

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• Suppose our cash flow estimates turn out to be
  too high by, say, 2.
• The cash flows would be.
• NPVA -100,000,000 108,878,000 / 1.1
  -1,020,000
• NPVB -1,000,000 2,155,999 / 1.1 959,999

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• Notice that the NPV of A is now negative, while
  the NPV of B is still large and positive. This
  suggests that we should take Project B.
• Why?
• There is more room for error in our estimates
  with Project B.
• Notice also that the IRR for Project B is much
  higher than the IRR for Project A
• IRRA (111,100,000 - 100,000,000) /
  100,000,000 11.1
• IRRB (2,199,999 - 1,000,000) / 1,000,000
  119.99 !!
• This illustrates why that we should always look
  at the IRR on projects in addition to the NPV.

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• The NPV always gives the correct decision when
  projects are independent (meaning that we can
  take any or all of them).
• When projects are mutually exclusive, the NPV
  rule may give an incorrect decision. In those
  cases, we need to come to some subjective
  conclusion based on all the evidence.
• Why might projects be mutually exclusive?
• capital constraints
• management constraints
• resource constraints

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• What cash flows are relevant to the project
  decision?
• example Suppose that you have spent 1,000,000
  on a project already. If you abandon the project
  right now, you will get nothing. If you spend an
  additional 200,000, you will get a payoff on the
  project of 1,100,000. The cost of capital is
  10. What should you do?
• Argument 1 NPV -1,200,000 1,100,000/1.1
  -200,000
• Reject (abandon) the project.
• Argument 2 NPV -200,000 1,100,000/1.1
  800,000
• Continue the project
• Which is correct?
• Intuitively, we know that we should continue.
  Implication Any cost that has already been
  spent/committed should be ignored in NPV
  analysis.
• These costs are irrelevant and are called sunk
  costs.

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• The bottom line on relevant cash flows is the
  following.
• Any cash flow that is different if the firm takes
  the project than if the firm rejects the project
  is a relevant cash flow.
• These cash flows are called the incremental cash
  flows for the project.
• example Suppose that a firm is considering a
  project. If the project is accepted, the firm
  will sell some of its old equipment for
  2,500,000. The equipment has a book value of
  1,400,000. If the firms marginal tax rate is
  30, what is the cash flow for the sale?
• Is the cash flow relevant? yes.
• Cash flow Sale Price - Profits ? Tax Rate
  Market Value - (Market Value - Book
  Value) ? Tax Rate 2,500,000 - (2,500,000
  - 1,400,000) ? 0.3 2,170,000
• This type of cash flow is called a salvage cash
  flow.

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• example Suppose that a firm owns land that has a
  market value of 5,000,000. The firm is
  considering a project that will require the use
  of the land. What is the relevant cash flow for
  the land?
• Is the cash flow relevant? YES!
• If the firm accepts the projects, it gives up the
  ability to sell the land or do something else
  with it.
• The incremental cash flow here is the value of
  the best alternative use of the land.
• Assuming the best use is to sell it, the firm
  incurs an incremental cash flow of -5,000,000 if
  the project is accepted.
• Note we would also include any tax effect on
  the sale.

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• example Suppose that your firm is considering a
  project. If the project is accepted, the firm
  will have to create a cash account of 200,000 to
  handle net working capital requirements. The
  project will last for 6 years.
• Are there relevant cash flows here? yes
• The firm will have to "deposit" 200,000 at the
  beginning of the project, so there will be a cash
  outflow of 200,000 at that time.
• At the end of the project, the firm will be able
  to close the account, so there will be a cash
  inflow of 200,000 at that time.
• Any impacts on net working capital accounts
  (current assets and current liabilities) are
  considered relevant cash flows.
• Notice that we recover the net working capital
  at the end of the project. When the project is
  over, we will no longer need the net working
  capital, so we are able to use the funds for
  other purposes

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• example Suppose that Dell Computer is
  considering a project in which it will introduce
  a new line of computers. These computers will be
  in direct competition with Dell's current line of
  Pentium computers. As a result, Dell expects
  decreased profits (after-tax) of 54,000,000 per
  year.
• Are there relevant cash flows here? yes
• If Dell introduces the new line, it will have
  decreased sales of Pentium computers. If it
  doesn't introduce the line, sales of Pentium
  computers will not decrease.
• Relevant cash flow -54,000,000 per year.
• This type of cash flow is called an externality.
  If an externality results in decreased sales for
  other products, the externality is called
  cannibalization.

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• Accounting Numbers vs. Relevant Cash Flows
• example Suppose that a company has the
  following income statement.
• What is the relevant cash flow?

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• What are the relevant cash flows?

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• Total Cash flow 400,000 - 275,000 - 10,000
  115,000
• The taxes are calculated as (Sales - Costs -
  Depreciation) ? Tax Rate, so we calculated the
  total cash flow as CF S - C - (S - C - D) ? T.
  Rearranging this, we get CF (S - C) ? (1-T)
  D ? T
• This cash flow called the operating cash flow.
• Notes
• Sales do not, in general, equal receipts from
  sales (since some sales are made on accounts
  receivable).
• Cost of Goods Sold does not, in general, equal
  the disbursement for projects (since some
  purchases are made on accounts payable).
• Fortunately, the adjustments for those
  discrepancies are taken care of when we include
  the change in net working capital as a cash flow.

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• The Weighted Average Cost of Capital (WACC)
• definition the cost of capital is the firm's
  marginal cost (as a percentage) of acquiring
  capital, given that the firm maintains its
  current debt/equity/preferred stock
  distribution.
• Cost of Equity (or.the Cost of Retained
  Earnings)
• Suppose that a firm is all-equity and that the
  firm intends to stay that way. What is the
  firm's cost of borrowing money?
• Investors will demand an interest rate (in
  expectation) that compensates them for the
  non-diversifiable risk they face.

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• Diversifiable (unsystematic or irrelevant) risk
  vs. Non-diversifiable (market or systematic or
  relevant) risk
• Important point Investors will only be
  compensated for the risk that they would face
  given that they reduce it as much as possible.
  If they do not choose to diversify, they will not
  be compensated for the extra risk they have
  voluntarily chosen to take.
• The risk that remains after it has been reduced
  as much as possible is called non-diversifiable
  risk.
• risk associated with macroeconomic conditions
  such as inflation, changes in taxation, changes
  in trade policies, etc.
• The risk that has been taken away is called
  diversifiable risk.
• risk associated with only the firm, such as
  chance of a manufacturing plant fire, chance of e
  coli in food products, etc.
• Why is this diversifiable risk?

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• The Capital Asset Pricing Model (CAPM)
• KE Rf ?(Rm-Rf)
• ? measure of the non-diversifiable risk of the
  stock.
• ? 1..investment has the same non-diversifiable
  risk as the market.
• ? 0.investment has no non-diversifiable risk
  (Treasury bills, for instance).
• ? lt 0.investment is negatively correlated with
  the market (gold perhaps). These can be very
  useful for diversification.
• 0 lt ? lt 1.investment has less non-diversifiable
  risk than the market.
• ? gt 1.investment has more non-diversifiable risk
  than the market.

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• Cost of Debt
• What is the firm's interest rate on debt?
• easy to measure because we can readily observe
  the yield on existing debt
• must adjust the cost for the interest tax
  deduction
• cost of debt ? KD
• after-tax cost of debt KD(1-t), where t is the
  company's tax rate
• Example Suppose a company has bonds outstanding
  with 5 years to maturity, 10 annual coupons, and
  a market price of 980. The company's marginal
  tax rate is 40.
• What is the cost of debt? KD 10.53
• What is the after-tax cost of debt? KD (1-t)
  10.53 (1-0.4) 6.32
• Notice that because of the tax advantage, it is
  typically fairly cheap to borrow by issuing debt.

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• Cost of Preferred Stock
• There is no tax advantage (typically) on
  preferred stock.
• easy to calculate because preferred stock is
  really just a perpetual bond
• Example Suppose that a company has preferred
  stock that currently sells (on the open market)
  for 34 per share. The promised dividend is 4
  per year. What is the cost of the company's
  preferred stock?
• KPS DPS / P 4/34 0.1176 11.76

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• Weighted Average Cost of Capital
• Notice that D, E, PS, and TA (which is DEPS)
  should be included as market values.
• Why?
• The WACC is the appropriate discount rate to use
  for projects because it gives us the firm's
  average cost of borrowing.
• Said differently, it is the amount of money that
  must be paid out of firm profits to satisfy all
  the firms investors.

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• example Suppose that a firm is financed with
  40M debt, 10M preferred stock, and 50M common
  equity. What is the WACC? Further information
• debt currently, the firm has an 8 annual
  coupon, 10 year bond that sells for 1000.
• preferred stock currently the firm has
  preferred shares outstanding that sell for
  27.50. The promised dividend is 3.
• common equity The company has a beta of 1 and
  the expected market return is 11.25.
• marginal tax rate 38
• What is the firm's WACC if the firm plans to
  finance with new issues?
• KD 8 (since the bonds sell at par)
• KPS D1/P 3/27.50 10.909
• KE 11.25 (since the beta is 1)
• WACC 0.4 (8) (1-0.38) 0.1(10.909) 0.5
  (11.25) 8.7

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• Questions
• What if the company is not publicly-traded?
• What is the project under consideration differs
  from the companys current projects?
• In theory, the WACC should be the interest rate
  that compensates investors for the level of
  non-diversifiable risk associated with the
  project. We can use the companys WACC only if
  the project under consideration is similar in
  risk to the rest of the company. If not, we use
  what is called the pure play approach.
• Pure Play Approach
• 1. Identify public companies that work in the
  line of business we are considering.
• 2. Estimate the WACCs for those companies.
• 3. Use those estimates to find the appropriate
  discount rate for the project.

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• Equivalent Annual Annuities
• Example A company is considering two projects,
  but may only choose one of them. The companys
  WACC is 9. The expected cash flows of those
  projects are as follows.
• Which project should the company choose?
• NPVA 749,806 NPVB 1,058,561

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• It appears that B is the better project, but
  notice that B ties up the firm for 5 years, while
  A ties it up for 3 years. An advantage of A is
  that the firm might be able to earn additional
  profits in years 4 and 5. How can we take that
  into account?
• Equivalent Annual Annuity ? the annuity payment
  over the life of the project that would give the
  same NPV as the project itself.
• Project A
• C/1.09 C/1.092 C/1.093 749,806 ? C
  296,215
• Project B
• C/1.09 C/1.092 C/1.093 C/1.094 C/1.095
  1,058,561 ? C 272,148
• So, project A provides more value per year and
  therefore is preferred to project B.

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• Other measures of value
• payback
• discounted payback
• adjusted net present value
• economic value added (EVA)
• The Importance of Sensitivity Analysis
• Examples
• see handout

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• 1 A company is considering a project that
  requires an initial investment of 24M to build a
  new plant and purchase equipment. The investment
  will be depreciated as a MACRS 7-year class (see
  p. 21 in the text) asset. The new plant will be
  built on some of the company's land which has a
  current, after-tax market value of 4.3M. The
  company will produce units at a cost of 130 each
  and will sell them for 420 each. There are
  annual fixed costs of 0.5M. Unit sales are
  expected to be 150,000 each year for the next 6
  years, at which time the project will be
  abandoned. At that time, the plant and equipment
  is expected to be worth 8M (before tax) and the
  land is expected to be worth 5.4M (after tax).
  To supplement the production process, the company
  will need to purchase 1M worth of inventory.
  That inventory will be depleted during the final
  year of the project. The company has 100M of
  debt outstanding with a yield-to-maturity of 8,
  and has 150M of equity outstanding with a beta
  of 0.9. The expected market return is 13 and
  the risk-free rate is 5. The company's marginal
  tax rate is 40. Should the project be
  accepted?

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• Solution to 1
• WACC
• wD 100M / 250M 0.4
• kD 8wE 150M / 250M 0.6
• kE 5 0.9?(13 - 5) 12.2
• ? WACC 0.4?8?(1-0.4) 0.6?12.2 9.24
• Capital Expenditure
• -24M at date 0

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• Salvage cash flow of new equipment in 6 years
• Salvage CF 8M - 0.4?(8M - 3.212M) 6.085M
• Change in Net Working Capital
• -1M at date 0 1M at date 6
• Operating Cash Flows
• Sales 150,000 ? 420 63,000,000
• Costs 150,000 ? 130 0.5M 20,000,000
• OCF (S - C) ? (1-0.4) D ? 0.4
  25,800,000D?0.4

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• Other Relevant Cash Flows Land
• The 4.3M is an opportunity cost and must be
  included at date 0.
• If the project is accepted, however, the land can
  be sold in 6 years for 5.4M. Is this an
  incremental cash flow? Yes, because we wouldn't
  be selling it then if we reject the project.
• Putting all this together gives us the total
  expected incremental cash flows for the project

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• NPV -29.3 27.172/ 1.0924 39.141/1.09246
  99.37M gt 0IRR 92.53 gt 9.24
• ? Accept the project