Introduction to Capital Budgeting

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Introduction to Capital Budgeting

• Use tools developed thus far to make investment
  decisions.
• Based on cash flows (watch out for taxes)
• Time value of money
• Risk
• Decision making criteria
• Sensitivity analysis and forecasting
• Basic Idea take investments where the benefits
  exceed the costs after adjusting for the risk and
  timing of the cash flows.

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Steps in Capital Budgeting Process

• Estimate project cash flows
• Estimate project risk
• Account for project interactions
• Apply decision making criteria

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Key Points to Keep in Mind

• Only cash flows are relevant
• Treat inflation consistently
• Pay attention to all taxes
• Focus on incremental CF
• Average versus incremental payoffs
• Incidental effects
• Remember working capital
• Forget sunk costs
• Include opportunity costs
• Watch out for allocations
• Separate Investing and Financing decisions

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Taxes

• Taxes often complicate the problem at hand.
• Taxes on income
• Depreciation and other acctg. treatments DO
  affect the taxes paid.
• Taxes on capital gains/losses
• Capital gains/losses generate a tax event on the
  amount of gain or loss (sale price - basis).

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Average vs. Incremental Payoffs

• A firm has a division which generates cash flows
  of -10 million annually. By investing 5
  million more, the firm can increase CF to -9
  million in perpetuity.
• If the firm has a discount rate of 10, what
  should the firm do?
• Make investment PV -5 - 9/.1 -95
• No investment PV -10/.1 -100
• The firm should take the investment since it has
  a net positive impact of 5 million.

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Incidental Effects

• Last season, NBC renewed its contract for ER at a
  cost of 13 million per episode.
• Assume cash flows from advertising total 10
  million per episode.
• What kinds of incidental effects might justify
  the 3 million per episode shortfall?
• Benefits from award-winning show.
• Draws people to watch other shows on the network.
• Future benefits (reruns and ads).

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Working Capital

• A firm is planning to open a store. The store
  costs 1 million, requires 1 million in
  inventories and cash to get started, and should
  generate annual cash flows of 100,000 in
  perpetuity.
• At a 10 discount rate, what should the firm do?
• Total Investment 1 mil. 1 mil. 2 million
• NPV -2 mil. 100,000/.1 -1 million

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Opportunity Costs

• In the previous example, how would your analysis
  change if the firm already owned the store?
  Assume the firm paid 500,000 for the store last
  year.
• Since we could buy the store for 1 million, it
  must have a market value of 1 million.
• The total investment is still 2 million.
  Remember we want the present value of the initial
  investment.
• The firm should still not open the store.

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Sunk Costs

• A firm hires a consultant to evaluate an
  investment opportunity. The consultant charges
  250,000 for the services leading up to the
  recommendation.
• The consultants report shows an NPV of 100,000,
  but the consultants fees are not included.
• Did the consultant make a mistake by leaving the
  fees out?
• If the consultant is retained for ongoing
  advising about the investment, should these fees
  be included?

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Allocations

• You are presenting your divisions capital
  request to your corporations executive committee
  for their approval.
• They are impressed by the business opportunity,
  but question the 11 million NPV since your
  analysis does not include the 10 of sales
  allocation for corporate overhead.
• What is your response?

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Project Interactions

• Optimal timing of investment
• Assets with different lives
• When to replace a machine
• Cost of excess capacity
• Fluctuating load factors
• Options in capital budgeting

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Optimal Timing of Investment

• In many cases, investment opportunities can be
  undertaken now or deferred until the future.
• To solve this problem, calculate the value of the
  project at each possible starting point, discount
  back to the present, and choose the one with the
  highest NPV.

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Investment Timing Example

• You own a tract of timber that can be harvested
  now or at the end of each year for the next five
  years.
• Suppose the harvest generates cash flows of 1
  million if done today. Deferring causes cash
  flows to increase at a decreasing rate.
  Specifically, the annual growth rate is 15 for
  the first year, then declines by 2 each year
  down to 7 for the last year.
• When should you harvest if the discount rate is
  12 for all years?

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Investment Timing Example

• Year 2 has the highest NPV.
• When the FV increases at a decreasing rate,
  choose the period where the marginal FV growth
  equals the marginal discount rate.

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Assets with Different Lives

• Often there is a choice between different assets
  to perform some task.
• We can not just compare the cost of two assets if
  they have different lives.
• We need to adjust the total costs to get annual
  costs, adjusted for present value effects.

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Example Assets with Different Lives

• Suppose you need to buy a PC. A high-end
  Pentium-450 will cost you 2800 and last for 4
  years. A Pentium-350 is only 1600, but will
  last for just 2 years.
• Using a 16 discount rate, which one is a better
  deal?
• We use Equivalent Annual Cost to make this
  decision.

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Example Assets with Different Lives

• Life Avg. EAC
• (Yrs) PV Ann Cost _at_ 16
• P-350 2 1,600 800 997
• P-450 4 2,800 700 1001
• For P-350,
• A full analysis would take into account future
  replacement values as well.
• We also assume the computers are worthless after
  their specified lives.

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When to Replace?

• Extend the previous example by assuming that you
  are currently leasing a computer.
• The lease is 900 this year and 1100 next year.
• You can terminate the lease at the end of a year
  without any penalty.
• The question then is when would you want to buy a
  computer?
• From the previous example, it costs roughly 1000
  per year to buy a computer. Assume the EAC will
  be the same if you buy one of these computers
  next year.
• You should lease this year and buy next year.

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Cost of Excess Capacity

• UNC bought a Silicon Graphics computer for about
  300,000.
• Suppose that under projected usage, the machine
  has a life of 5 years (after that it is
  worthless).
• Suppose that every 5 years, the university will
  replace the computer at the same cost.
• The registrars office (assume it does not have
  access to the machine already) wants to use the
  computer to process grades and schedules. It
  points out that the computer has idle cycles so
  that there should be no charge for using it.
• Assume the load from the registrars processing
  shortens the life of each computer from 5 years
  to 4 years.
• How much should the registrar pay (use a 10
  discount rate).

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Cost of Excess Capacity

• View the cost of the computers as a perpetuity.
• Without the registrar, it pays 300,000 once
  every 5 years. The discount rate must reflect
  the 5 year interval.
• With the registrar, it pays 300,000 once every 4
  years. The difference in the PVs reflects the
  registrars usage.

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Cost of Excess Capacity, Revisited

• What if the extra usage moved the purchase of the
  first computer from year 5 to 4, but all
  subsequent computers still lasted 5 years?
• First calculate the EAC.
• Now we make an extra payment in year 5. Today
  this is worth 79,139/(1.1)5 49,139.

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Fluctuating Load Factors

• You produce a perishable good using two machines.
  You sell 1200 units year-round, but the Spring
  and Summer quarters represent 400 units each,
  while in each of the other quarters production is
  only 200 units.
• Your current machines cost 2/unit to run, but
  there are no fixed costs and they will last
  forever. Each machine can produce 800 units per
  year.
• At a 10 discount rate, what is the present value
  the costs in perpetuity?
• PV (12002)/.1 24,000

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Fluctuating Load Factors

• Now suppose new machines cost 5000 each, but
  operating costs are only 1/unit.
• PV costs 50002 1200/.1 22,000.
• Since one new machine can produce all units in
  Fall/Winter, you could buy just one new machine.
• PV 5000 800/.1 (4002)/.1 21,000.

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Options in Capital Budgeting

• An option is the right, but not the obligation,
  to do something in the future.
• Undertaking a project now may give the firm
  options, or choices, about future projects.
• Option to expand
• Option to abandon
• Option to wait
• Strategic options
• The value of these options can be sizable, and
  they should be included in project analysis.

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Capital Rationing

• Ideally a firm will take all positive NPV
  projects.
• In practice, a firm may face capital rationing,
  meaning it does not have enough capital to take
  all good projects.
• In these cases, a firm must choose which of the
  good projects to take.
• Intuitively, the firm should choose the projects
  with the most bang for the buck.

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Capital Rationing

• The NPV rule identifies the best project in terms
  of magnitude.
• PI identifies the projects offering the highest
  return.
• One Solution Rank order on PI, pick all projects
  with PI gt 1 until all money is spent.
• Linear Programming offers a better solution.

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Capital Rationing Example

• CF (mil.) NPV
• Proj. t0 t1 t2 _at_ 10 PI
• A -10 30 5 21 3.1
• B -5 5 20 16 4.2
• C -5 5 15 12 3.4
• If capital budget is 10, chose B and C. NPV
  28.
• If capital budget is 15, chose A and B. NPV
  37.

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Why is Capital Rationed?

• Access to external capital markets is imperfect.
• Expensive (float costs, etc.)
• Informational asymmetry issues.
• Internal capital markets
• Costly (time-consuming) budget approval process
• Internal politics
• Strategic direction of firm

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A Worked Example Computer Chips

• RD to date 500 million (gets patent)
• Additional RD 250 million
• Plant 1 billion 5 yr. full SL depr. 200 mil
  salvage
• Increase Cash 75, A/R 100, A/P 50 (in
  mil.)
• Revenue 1 billion/year for 5 years
• Operating Expense 400 million/year for 5 years
• Tax rate 40
• Discount Rate 12
• Synergies will increase video card CF by 20
  mil/year
• OH allocation 10 sales actual OH incr. 50
  mil.

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Worked Example Solution
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Another Point of View Break-Even

• Much of the analysis we have discussed in this
  section tried to identify the value of a project.
• Another approach that may be more useful in
  practice is to ask
• How much can my key assumptions change before my
  investment decision changes?

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Break-Even Analysis

• The break-even point can be measured in different
  ways
• Accounting break-even (NI 0)
• Cash break-even (OCF 0)
• Financial break-even (NPV 0)
• The variables you examine could include
• Sales volumes (units) or prices
• Variable Costs or margins
• Fixed Asset investments

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Leverage

• The idea of leverage is how changes in an input
  variable are magnified to an outout variable.
• Operating leverage measures how sensitive
  operating cash flow is to changes in revenue.
  Fixed costs act as the lever.
• Financial leverage measures how sensitive the
  cash flows to shareholder are to changes in total
  cash flows. Debt is the lever here.

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Operating Leverage

• Operating leverage fits in with project analysis
  since it measures the reliance of a project on
  fixed costs.
• High operating leverage means the project has
  relatively high fixed costs.
• Low operating leverage means the project has
  mostly variable costs.

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Operating Leverage Illustration

• Consider Projects A and B.
• Both have sales of 1/unit and expect to sell
  1000 units.
• A has 500 fixed cost and variable costs of
  0.50.
• B has 900 fixed cost and variable costs of
  0.10.
• The Cash break-even is at 1,000 units.
• OCF for A is less sensitive to deviations in
  units sold than B.

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Operating Leverage Illustration
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Operating Leverage

• The slope of the line in the prior graph indicate
  the change in OCF for a change in units sold.
• For A, slope (50-0)/(1100-1000) 0.5
• For B, slope (90-0)/(1100-1000) 0.9
• Each incremental unit sold raises OCF by 0.50
  for A and 0.90 for B. B is more sensitive to
  unit sales than A.

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Degree of Operating Leverage

• Degree of Operating Leverage (DOL) is another
  measure of the sensitivity of OCF to Revenue.
• From the previous example
• When units 1100, DOLA 1 500/50 11
• When units 1200, DOLA 1 500/100 6
• A 1 increase in units causes OCF to increase by
  11 (6) at 1100 (1200) units.

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