Ch' 10 Capital Budgeting

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(Ch. 10) Capital Budgeting

• Evaluating Cash Flows
• Week 5 Joint MBA - Finance 5000
• Webster-SHUFE-2009
• Shanghai

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How do companies increase value?

• Of course the answer is by performing better and
  better and increase NOPAT
• But at least as important is that companies make
  wise and calculated investments
• Capex is a main cash out for companies
• How do they get a feel for if these investments
  will create new additional NOPAT in the future?
• The answer is with capital budgeting!

Invest in China?
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We consider different kinds of companies

• These who have a wide variety of viable
  investments but not enough money to back these
  plans
• These companies that are phenomenally cash rich
  and basically do not have enough investment plans
  to spend all their money (Microsoft, Johnson
  Johnson)

Investing to rationalize
Investing to expand.
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New capital projects

• Can be extensions from what the company is
  already doing (relatively low risk)
• Can be development of entirely new
  products/markets (relatively high risk)
• Can be major refurbishments of equipment or
  maintenance (relatively low risk)
• Can be investment in new technologies (high risk)
• Can be replacements of old equipment/machines
• Can be investment in safety, housekeeping,
  environment
• Can be many many other things.
• Can be strategic, operational, market oriented or
  operations oriented.and vary widely in risk
  profile!

Investing in warehouse space?
5
The decision rules

• Every investment has a cash out at the beginning
  of the project
• Sometimes the cash payments are spread over more
  years
• Sometimes due to the way of financing the cash
  out is yearly over a longer period of time
  (leasing)
• The typical model though is
• Cash Out at the beginning of the project
• Cash Ins (returns from the project) in later
  years

Cash in? Cash out?
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Pay Back Period (PBP)

• The PBP tells us after what time the initial
  investment has been paid back by the project
• Say I -1000 (t0)
• And in period 1 (t1) the cash in is 500
• In t2 400
• In t3 300
• In t4 100
• Then this investment will pay back in 2 years
  900 and in t3 300 so the last 100 is 0.33
  year in total 2,33 years
• Obviously the shorter pay back an investment
  project has the better
• This method is hardly used anymore since it does
  not take into account the time value of money

PBP?
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Discounted PBP

• If the projects cost of capital is similar to
  that of the company you can use the WACC to
  discount the cash inflows of
• t1 as 500/(1wacc)
• t2 as 400/(1wacc)2
• t3 as 300/(1wacc)3
• You then can use the same methodology to find the
  PBP using the discounted cash flowsof course you
  will find a longer PBP now
• We now have taken into account the time value of
  money
• Still this method is not used very often since
  there is a better method

Discounted PBP?
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Net Present Value

• The NPV of a project is the discounted cash flow
  of all cash out-and inflows
• So following our example and assuming the project
  is average company risk we discount at the WACC
  (assume 10)
• The NPV of the project is 78.82
• So after covering the cost of capital the project
  still generates a positive cash flowthus
  indicating to add value for the company in the
  future
• Normally the management of the company will
  accept to execute such a project

What NPV did Lufthansa calculate?
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IRR

• The Internal Rate of Return will give you the
  discount factor at which the total cash outflows
  of a project equal the total inflows over its
  life
• In other words we now calculate the yield at
  which the NPV of the project is zero!
• After calculating IRR we can compare the cost of
  capital of the project if IRRgtcost of capital
  this project will increase the companies valuein
  the other case the project will not cover the
  cost of capital and will not be executed

IRR?
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Note that sometimes IRR can generate more then
one result

• Assume Initial cash out -1600
• Cash in t1 is 10,000
• Cash out t2 is 10,000
• What is IRR (use Excel)
• IRR is 25 and 400...

DEMO
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Modified IRR (MIRR) is a better measure

• We now calculate the Future Value of all cash
  flows except the initial cash outlay
• We then find the discount factor (IRR) that
  forces the present value of the sum of the future
  values of the cash flows to be equal to the
  initial cash outlay

DEMO
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Using Excel

• You can use Excel to solve IRR and NPV its
  highly recommended to use Excel above a
  calculator

DEMO
13
Using Excel
Note that since spread sheets calculate with many
digits the results are very precise!
DEMO
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So what to use ?

• Despite the academic preference to use NPV
  business people do prefer IRR
• More advanced capital budgeting departments use
  MIRR
• A Modified IRR (page 520 textbook)
• The Modified IRR assumes that all cash ins
  during the projects life can be reinvested at
  the Cost of Capital (WACC)
• The MIRR is the that makes the NPV of all cash
  outs (discounted at WACC) equal to the NPV of
  the Future Value (at the end of the project at
  WACC)
• So now we take an extra step

Wonder what MIRR is?
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Example MIRR

• Project cash flows
• T0-1000
• T1500
• T2400
• T3300
• T4100
• Calculate the FV of all positive CFs at the end
  of project (end of year 4) at WACC (assume 10)
• You will find 1,579.50
• What IRR will make this equal to the sum of the
  NPV of all cash outs ( 1000)
• (M)IRR 12.1

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Test the answer with Excel
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MIRR

• So the MIRR assumes that cash flows from the
  project will generate the WACC (and not the
  IRR)
• It also finds a unique solution in case cash
  flows alternate during the project (from positive
  to negative to positive etc.)
• We illustrate one more example in case of
  alternating cash flows

Great Wall Street ?
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Example MIRR

• Project cash flows
• T0-1000
• T11500
• T2-400
• T3300
• T4-100
• Calculate the FV of all positive CFs at the end
  of project (end of year 4) at WACC (assume 10)
  you will find 2326.50
• You will find What IRR will make this equal to
  the sum of the NPV of all cash outs (sum of NPV
  of all cash outs at 10 is 1398.88) (M)IRR
  13.56)

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Excel can do it instantly
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Calculations in Excel
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Companies compare

• Projects risks
• Projects NPVs
• Projects (M)IRRs
• And based on their total assessment of the
  investment (including imponderables) make final
  choices for executing selected projects

OR
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Finally companies use

• Profitability Index (PI) The Present Value of
  future cash flows/Initial cash outflow
• Any index above 1 shows that the sum of future
  (PV) cash flows is higher then the initial cash
  outlay
• In our example the PI is PV(cash flows)/Initial
  cash outflow 1078,82/1000 1.079

Airbus A 380
The better performer
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Disney Hong Kong

• 3.5 bln USD project
• 5.6M visitors first year
• Ticket price RMB 300
• Will it pay off?

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Assignment Investment Proposal

• You are business unit manager of the company you
  selected
• Currently you see a large investment opportunity
  in China (yes!)
• However you will have to convince your Board of
  investing 150 Mln. (no small money)
• Your Board is very strict on large Capex and you
  will need to make a formal investment proposal
  consisting of
• Description of the investment you want to do in
  China
• Motivation of this investment
• Strategic Context of the investment
• Timing
• Risks and uncertainties (is this the first
  investment in China?)
• Cost Savings, and/or extra sales revenues and
  profit development
• Working capital impact
• Maintenance capex in the future
• Currency and Macro-economic environment
• Cash flows
• WACC of your company and the cost of capital of
  this investment
• Consider a worst case scenario and a base case
  scenario

BOEING 7E7
The nicer toy
End of chapter 13