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Agenda

Capital Budgeting Decision Frameworks

Capital Budgeting Process

Goal of management is to maximize value

Companies continually invests in a portfolio of projects

In theory all projects that create value should be approved

In reality, a company may not invest in all projects estimated to create value

Capital budgeting is the process to assess:

if an investment will create value for the investors

Expected project return > cost of capital

If constrained, how to prioritize across investments.

Capital constraints

Non-Capital constraints

Estimation Bias

Describe process to create a budget

ZBB process

What would you like to see in approving a project

Capital Budgeting

New Product

Upgrade the Factory

Marketing Program

Open new Sales office

Leadership Training

‘Big Data’ Software

New Feature for existing product

Compliance with new Federal regulation

Capital Budgeting Process

Approved Projects

The Capital Budgeting Decision Process

The capital budgeting process involves a few basic steps:

Identifying potential investments

Ensure potential investments are linked to strategic direction

Types of Projects: Safety, Replacement, Contraction, Expansion (products or markets), Mergers

Reviewing, analyzing, and selecting from the proposals that have been generated

Strategic Alignment

Does the project create value?

Implementing and monitoring the proposals that have been selected

Analyzing involves valuing the project -> same principles as valuing a security or business

A capital budgeting process should…

Be easy to apply and explain

Focus on cash flow

Account for the time value of money

Account for project risk

Lead to investment decisions that maximize shareholders’ wealth

Investment Decision Frameworks

Net Present Value (NPV)

Internal Rate of Return (IRR)

Modified Internal Rate of Return (MIRR)

Profitability Index

Payback

Discounted Payback

All frameworks will require a financial forecast

Most require size of cash flows, timing of cash flows and risk.

Typical profile: investment in development, marketing, capital and inventory

revenue ramp and then transition down

costs to support and then reclaim of some investment

Does the profile make economic sense? Create value

What Companies Do Globally

Project Analysis General Framework

What are the cash flows associated with the project

Understand the strategy and operational assumptions related to the project

Forecast the pro forma financials

Income statement and balance sheet

Percent of sales approach as starting point

Utilize ratios & competitive positioning to guide assumptions

Free Cash flow = CF from Operations - Investment in WC – Investment in LT Assets

Only new, incremental cash flows should be included

Assess riskiness of cash flows: Discount Rate

WACC: Cost of Equity (CAPM) and Cost of Debt (after tax yield)

Market based costs and Target or Market weights

Risk based on the project cash flows, not necessarily that of the company

Apply decision criteria (NPV, IRR, payback)

NPV generally the best method

Test the decision and the critical assumptions

What are the key inputs that have the most uncertainty?

What causes the decision to change?

Utilize Scenarios, Sensitivity, Breakeven to focus on key assumptions

Recommendation with key risks identified and suggestions to mitigate

Capital Budgeting Decision Frameworks

Net Present Value

Present Value of all future cash flows

Discount rate based on risk of project

Acceptance Criteria: NPV > $0

NPV Amount = amount of value creation

IRR / MIRR

Discount rate that results in NPV = 0

Cash flow forecast same as NPV analysis

Acceptance Criteria: IRR > Cost of Capital

Profitability Index

Present Value of Cash Inflow divided by

Present Value of Cash Outflow

Cash flow forecast same as NPV analysis

Acceptance Criteria: PI > 1.0

Payback

Numbers of time periods required to

recoup the investment

Cash flow forecast same as NPV analysis

Acceptance Criteria: Arbitrary

NPV Profile

Project NPV

Discount Rate

NPV > $0

IRR > Discount Rate

NPV < $0

IRR < Discount Rate

IRR of Project

NPV versus IRR

NPV and IRR will generally give the same decision.

Exceptions:

Mutually exclusive projects

Scale is substantially different

Timing of cash flows is substantially different

Non-conventional cash flows – cash flow signs change more than once

Modified IRR can help with the non conventional cash flows and re-investment rate assumptions

Profiles of non traditional CFs

Reinvest rate assumptions:

NPV= cost of capital

IRR= IRR

MIRR, define the reinvestment rate

MIRR

Example

Company is considering investing in a new product requiring $35M in R&D and $125M in capital equipment.

Total available market (TAM) size is 400M units / year. Company expects to address 15% of TAM and initially capture 2% market share.

Product price is $70 / unit

COGS is 40% of price

Sales and Marketing expense is estimated at 10% of revenue. General and administrative is 5% of revenue

Working capital is forecast as:

A/R at 10% of sales, Inventory at 15% of sales, A/P at 8% of sales

Depreciation based on 3 year MACRS

Tax rate is 35%

Product life is approx 4 years. Equipment will have a $10M salvage value

Cost of capital = 10%

Should the company invest in the new product?

Which Cash Flows -> Incremental Cash Flows

Cash flows matter—not accounting earnings.

Incremental cash flows matter.

Sunk costs do not matter.

Don’t forget start-up and salvage value cash flows

Opportunity costs matter.

Externalities like cannibalism and erosion matter.

Inflation matters.

Taxes matter: we want incremental after-tax cash flows.

Depreciation

Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes.

Accelerated depreciation methods such as the modified accelerated cost recovery system (MACRS) increase the present value of an investment’s tax benefits.

Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life.

Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements?

For capital budgeting analysis, it is the depreciation method for tax purposes that matters.

Assignments for Next Class

Investment Decisions and Risk Analysis Chapter 11

Summary – Investment Decision Frameworks

Net present value

Difference between market value and cost

Accept the project if the NPV is positive

Has no serious problems

Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return

Same decision as NPV with conventional cash flows

IRR is unreliable with non-conventional cash flows or mutually exclusive projects

MIRR can address the non-conventional cash flow issue

Profitability Index

Benefit-cost ratio

Take investment if PI > 1

Cannot be used to rank mutually exclusive projects

May be used to rank projects in the presence of capital rationing

Payback

Time required to recoup the initial investment

Does not account for timing, risk or cash flows beyond payback period

Payback decision criteria is arbitrary

NPV is preferred

Benefits of other methods -> provide insight on margin of safety

A B

NPV $10M $10.5M

IRR 30% 12%

Investment $5M $60M

Example

A company has two potential projects to invest in:

Each has a cost of capital of 10%

What would you recommend?

Net Present Value

r represents the minimum return that the project must earn to satisfy investors.

r varies with the risk of the firm and/or the risk of the project.

A key input in NPV analysis is the discount rate.

Net Present Value (NPV) = Total PV of cash inflows – PV of costs

Minimum Acceptance Criteria: Accept if NPV > 0

Internal Rate of Return

IRR found by computer/calculator or manually by trial and error

The IRR decision rule is:

If IRR is greater than the cost of capital, accept the project.

If IRR is less than the cost of capital, reject the project.

Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project.

Similar to a YTM calculation

Significance of IRR / NPV=0 ?

Pros and Cons of Using NPV as Decision Rule

NPV is the “gold standard” of investment decision rules.

NPV is the present value of cash inflows less present value of cash outflows

How much the project contributes to shareholder wealth

Key benefits of using NPV as decision rule

Focuses on cash flows, not accounting earnings

Makes appropriate adjustment for time value of money

Can properly account for risk differences between projects

Though best measure, NPV has some drawbacks.

Lacks the intuitive appeal of payback

Doesn’t capture managerial flexibility (option value) well

Pros and Cons of Payback Method

Computational simplicity

Easy to understand

Focus on cash flow

Disadvantages of payback method:

Does not account properly for time value of money

Does not account properly for risk

Cutoff period is arbitrary

Does not lead to value-maximizing decisions

Advantages of payback method:

The Profitability Index (PI)

Minimum Acceptance Criteria:

Accept if PI > 1

Ranking Criteria:

Select alternative with highest PI

Advantages:

Easy to understand and communicate

Correct decision when evaluating independent projects

Disadvantages:

Problems with mutually exclusive investments

Present Value of Future Cash Flows

Initial Investment

Initial Cost

01234

Project S

-$10,000$5,000$4,000$3,000$1,000

Project L

-$10,000$1,000$3,000$4,000$6,750

After-Tax, End of Year, Project Cash Flows, CF