capital budgeting

7/17/2019 Capital Budgeting

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CAPITAL BUDGETING



1. INTRODUCTION

• Capital budgeting is the allocation of funds to lon!li"ed ca#ital #$o%ects.

• A capital project is a lon!te$& in"est&ent in tani'le assets.

• The #$inci#les and tools of ca#ital 'udetin a$e a##lied in &an( diffe$entas#ects of a 'usiness entit()s decision &a*in and in secu$it( "aluation and#o$tfolio &anae&ent.

• A co&#an()s ca#ital 'udetin #$ocess and #$o+ess a$e i&#o$tant in "aluin aco&#an(.

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-. TE CAPITAL BUDGETING PROCE22

Gene$atin Ideas2te# 1• Gene$ate ideas f$o& inside o$ outside of the co&#an(

Anal(3in Indi"idual P$o#osals2te# -• Collect info$&ation and anal(3e the #$ofita'ilit( of alte$nati"e #$o%ects

Plannin the Ca#ital Budet2te# /• Anal(3e the fit of the #$o#osed #$o%ects +ith the co&#an()s st$ate(

4onito$in and Post Auditin2te# 5• Co&#a$e e6#ected and $eali3ed $esults and e6#lain an( de"iations

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CLA22I07ING PRO8ECT2

Re#lace&ent

P$o%ects

E6#ansion

P$o%ects

Ne+ P$oducts

and 2e$"ices

Reulato$(92afet(9 and

En"i$on&entalP$o%ects

Othe$

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/. BA2IC PRINCIPLE2 O0 CAPITAL BUDGETING

Decisions a$e'ased on cashflo+s.

The ti&in of cashflo+s is c$ucial.

Cash flo+s a$einc$e&ental.

Cash flo+s a$e onan afte$!ta6 'asis.

0inancin costsa$e ino$ed.

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CO2T2; INCLUDE OR E<CLUDE=

• A sunk cost is a cost that has al$ead( occu$$ed9 so it cannot 'e #a$t of theinc$e&ental cash flo+s of a ca#ital 'udetin anal(sis.

• An opportunity cost is +hat +ould 'e ea$ned on the ne6t!'est use of theassets.

• An incremental cash flow is the diffe$ence in a co&#an()s cash flo+s +ith

and +ithout the #$o%ect.• An externality is an effect that the in"est&ent #$o%ect has on so&ethin else9

+hethe$ inside o$ outside of the co&#an(.

! Cannibalization is an e6te$nalit( in +hich the in"est&ent $educes cash flo+selse+he$e in the co&#an( >e..9 ta*es sales f$o& an e6istin co&#an(

#$o%ect?.

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CONENTIONAL AND NONCONENTIONALCA2 0LO2

Conventional Cash Flow (CF) Patterns

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oday ! " # $ %

C0 FC0 FC0 FC0 FC0 FC0

C0 C0 FC0 FC0 FC0 FC0

C0 FC0 FC0 FC0 FC0



CONENTIONAL AND NONCONENTIONALCA2 0LO2

&onconventional Cash Flow Patterns


oday ! " # $ %

C0 FC0 FC0 FC0 FC0 C0

C0 FC0 C0 FC0 FC0 FC0

C0 C0 FC0 FC0 FC0 C0



INDEPENDENT 2. 4UTUALL7E<CLU2IE PRO8ECT2

• hen e"aluatin &o$e than one #$o%ect at a ti&e9 it is i&#o$tant to identif(+hethe$ the #$o%ects a$e inde#endent o$ &utuall( e6clusi"e

! This &a*es a diffe$ence +hen selectin the tools to e"aluate the #$o%ects.

• 'ndependent projects a$e #$o%ects in +hich the acce#tance of one #$o%ectdoes not #$eclude the acce#tance of the othe$>s?.

• utually exclusive projects a$e #$o%ects in +hich the acce#tance of one#$o%ect #$ecludes the acce#tance of anothe$ o$ othe$s.

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PRO8ECT 2EUENCING

• Ca#ital #$o%ects &a( 'e seJuenced9 +hich &eans a #$o%ect contains an o#tionto in"est in anothe$ #$o%ect.

! P$o%ects often ha"e real options associated +ith the&K so the co&#an( canchoose to e6#and o$ a'andon the #$o%ect9 fo$ e6a&#le9 afte$ $e"ie+in the#e$fo$&ance of the initial ca#ital #$o%ect.




CAPITAL RATIONING

• Capital rationing is +hen the a&ount of e6#enditu$e fo$ ca#ital #$o%ects in ai"en #e$iod is li&ited.

• If the co&#an( has so &an( #$ofita'le #$o%ects that the initial e6#enditu$es intotal +ould e6ceed the 'udet fo$ ca#ital #$o%ects fo$ the #e$iod9 the co&#an()s&anae&ent &ust dete$&ine +hich of the #$o%ects to select.

• The o'%ecti"e is to &a6i&i3e o+ne$s) +ealth9 su'%ect to the const$aint on theca#ital 'udet.

! Ca#ital $ationin &a( $esult in the $e%ection of #$ofita'le #$o%ects.




5. INE2T4ENT DECI2ION CRITERIA

Net P$esent alue >NP?

Inte$nal Rate of Retu$n >IRR?

Pa('ac* Pe$iod

Discounted Pa('ac* Pe$iod

A"e$ae Accountin Rate of Retu$n >AAR?

P$ofita'ilit( Inde6 >PI?

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NET PRE2ENT ALUE

The net present value is the #$esent "alue of all inc$e&ental cash flo+s9 discounted tothe #$esent9 less the initial outla(;

>-!1?

O$9 $eflectin the outla( as C09

>-!-?

+he$eC0t Afte$!ta6 cash flo+ at ti&e t

r ReJui$ed $ate of $etu$n fo$ the in"est&entOutla( In"est&ent cash flo+ at ti&e 3e$o

If NP M ;• In"est; Ca#ital #$o%ect adds "alue

If NP ;

• Do not in"est; Ca#ital #$o%ect dest$o(s "alue

•

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E<A4PLE; NP

Conside$ the oofdstad P$o%ect9 +hich $eJui$es an in"est&ent of 1 'illioninitiall(9 +ith su'seJuent cash flo+s of - &illion9 / &illion9 5 &illion9and : &illion. e can cha$acte$i3e the #$o%ect +ith the follo+in end!of!(ea$cash flo+s;

hat is the net #$esent "alue of the oofdstad P$o%ect if the $eJui$ed $ate of$etu$n of this #$o%ect is :=


Pe$iodCash 0lo+>&illions?

191 -- // 55 :



E<A4PLE; NP

ime ine

2ol"in fo$ the NP;

NP -1H.5 &illion

•

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* ! " # $

19 - / 5 :



INTERNAL RATE O0 RETURN

The internal rate of return is the $ate of $etu$n on a #$o%ect.! The inte$nal $ate of $etu$n is the $ate of $etu$n that $esults in NP .

>-!/?

O$9 $eflectin the outla( as C0.9

>-!5?If IRR M r (required rate of return):

• In"est; Ca#ital #$o%ect adds "alue

If IRR r:

• Do not in"est; Ca#ital #$o%ect dest$o(s "alue

•

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E<A4PLE; IRR

Conside$ the oofdstad P$o%ect that +e used to de&onst$ate the NPcalculation;

The IRR is the $ate that sol"es the follo+in;


Pe$iodCash 0lo+

>&illions?

191 -

- // 5

5 :



A NOTE ON 2OLING 0OR IRR

• The IRR is the $ate that causes the NP to 'e eJual to 3e$o.• The #$o'le& is that +e cannot sol"e di$ectl( fo$ IRR9 'ut $athe$ &ust eithe$

ite$ate >t$(in diffe$ent "alues of IRR until the NP is 3e$o? o$ use a financialcalculato$ o$ s#$eadsheet #$o$a& to sol"e fo$ IRR.

• In this e6a&#le9 IRR 1-.-@;




PA7BACQ PERIOD

• The payback period is the lenth of ti&e it ta*es to $eco"e$ the initial cashoutla( of a #$o%ect f$o& futu$e inc$e&ental cash flo+s.

• In the oofdstad P$o%ect e6a&#le9 the #a('ac* occu$s in the last (ea$9 7ea$ 5;

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Period

Cash Flow

(millions)

+ccumulated

Cash flows 19 191 - - / :/ 5 1

5 : F5



PA7BACQ PERIOD; IGNORING CA2 0LO2

0o$ e6a&#le9 the #a('ac* #e$iod fo$ 'oth P$o%ect < and P$o%ect 7 is th$ee (ea$s9e"en th$ouh P$o%ect < #$o"ides &o$e "alue th$ouh its 7ea$ 5 cash flo+;


,ear Project -

Cash FlowsProject ,

Cash Flows

1 1

1 - -

- : :

/ 5: 5:

5 @



DI2COUNTED PA7BACQ PERIOD

• The discounted payback period is the lenth of ti&e itta*es fo$ the cu&ulati"e discounted cash flo+s to eJual theinitial outla(.

! In othe$ +o$ds9 it is the lenth of ti&e fo$ the #$o%ect to $each NP .

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E<A4PLE; DI2COUNTED PA7BACQ PERIOD

Conside$ the e6a&#le of P$o%ects < and 7. Both #$o%ects ha"e a discounted#a('ac* #e$iod close to th$ee (ea$s. P$o%ect < actuall( adds &o$e "alue 'ut isnot distinuished f$o& P$o%ect 7 usin this a##$oach.

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Cash Flows .iscountedCash Flows

+ccumulated

.iscountedCash Flows

,ear Project - Project , Project - Project , Project - Project ,

1. 1. 1. 1. 1. 1.1 -. -. 1H.: 1H.: .H: .H:- :. :. 5:./: 5:./: /:.@ /:.@/ 5:. 5:. /. /. /.- /.-5 @. . 5H./@ . :-.@/ /.-



AERAGE ACCOUNTING RATE O0 RETURN

• The average accounting rate of return >++/? is the $atio of the a"e$ae netinco&e f$o& the #$o%ect to the a"e$ae 'oo* "alue of assets in the #$o%ect;

•

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PRO0ITABILIT7 INDE<

The profitability index >P'? is the $atio of the #$esent "alue of futu$e cash flo+sto the initial outla(;

>-!:?

If PI M 1.;

• In"est

• Ca#ital #$o%ect adds "alue

If PI ;

• Do not in"est

• Ca#ital #$o%ect dest$o(s "alue

•

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E<A4PLE; PI

In the oofdstad P$o%ect9 +ith a $eJui$ed $ate of $etu$n of :9

the #$esent "alue of the futu$e cash flo+s is 19-1H.5. The$efo$e9 the PI is;

•

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Pe$iodCash 0lo+

>&illions?

!191 -

- // 5

5 :



NET PRE2ENT ALUE PRO0ILE

The net present value profile is the $a#hical illust$ation of the NP of a #$o%ectat diffe$ent $eJui$ed $ates of $etu$n.

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/e0uired /ate of /eturn

&etPresent

1alue

The NPV profile crosses thehorizontal axis at the project’s

internal rate of return.

The NPV profile intersects the

vertical axis at the sum of the

cash flows (i.e., 0% reuire! rate

of return".



NP PRO0ILE; OO0D2TAD CAPITAL PRO8ECT


!-!1

1-/5:


&P1(millions)



NP PRO0ILE; OO0D2TAD CAPITAL PRO8ECT


!O-..!O1..

O.O1..O-..O/..O5..O:..O5..O/@1O/-/O-GCO-:/O-1HO1GGO1:CO1-COHHOC-O5@O-.!O5!O-G!O:.!OC-!OH/!O115!O1//!O1:-


&P1(millions)



RANQING CON0LICT2; NP 2. IRR

• The NP and IRR &ethods &a( $an* #$o%ects diffe$entl(.! If #$o%ects a$e inde#endent9 acce#t if NP M #$oduces the sa&e $esult as

+hen IRR M r .

! If #$o%ects a$e &utuall( e6clusi"e9 acce#t if NP M &a( #$oduce a diffe$ent$esult than +hen IRR M r .

• The sou$ce of the #$o'le& is diffe$ent $ein"est&ent $ate assu&#tions

! Net #$esent "alue; Rein"est cash flo+s at the $eJui$ed $ate of $etu$n

! Inte$nal $ate of $etu$n; Rein"est cash flo+s at the inte$nal $ate of $etu$n

• The #$o'le& is e"ident +hen the$e a$e diffe$ent #atte$ns of cash flo+s o$diffe$ent scales of cash flo+s.

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E<A4PLE; RANQING CON0LICT2

Conside$ t+o &utuall( e6clusi"e #$o%ects9 P$o%ect P and P$o%ect ;

hich #$o%ect is #$efe$$ed and +h(=

Hint: It de#ends on the #$o%ects) $eJui$ed $ates of $etu$n.


2nd of ,ear Cash Flows

,ear Project P Project 3

1 1

1 //

- //

/ //

5 15- //



DECI2ION AT ARIOU2 REUIREDRATE2 O0 RETURN

Project P Project 3 .ecision

NP S 5- /- Acce#t P9 Re%ect

NP S 5 -1 - Acce#t P9 Re%ect

NP S @ 1- 15 Re%ect P9 Acce#t

NP S 1 / : Re%ect P9 Acce#t

NP S 15 1@ 5 Re%ect P9 Re%ect

IRR H.1@ 1-.11

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NP PRO0ILE2; PRO8ECT P AND PRO8ECT

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!O/.

!O-.

!O1.

O.

O1.

O-.

O/.

O5.

O:. NPA of P$o%ect P NPA of P$o%ect I


&P1



TE 4ULTIPLE IRR PROBLE4

• If cash flo+s chane sin &o$e than once du$in the life of the #$o%ect9 the$e&a( 'e &o$e than one $ate that can fo$ce the #$esent "alue of the cash flo+sto 'e eJual to 3e$o.

! This scena$io is called the &ulti#le IRR #$o'le&.

! In othe$ +o$ds9 the$e is no uniJue IRR if the cash flo+s a$e noncon"entional.

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E<A4PLE; TE 4ULTIPLE IRR PROBLE4

Conside$ the fluctuatin ca#ital #$o%ect +ith the follo+in end of (ea$ cash flo+s9in &illions;

hat is the IRR of this #$o%ect=

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,ear Cash Flow

V::

1 V5H

- V5H/ V5H

5 VH5



E<A4PLE; TE 4ULTIPLE IRR PROBLE4

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!V1-!V1!V!V@!V5!V-

V V- V5


&P1(millions)

IRR -.:@

IRR /5.-5H



POPULARIT7 AND U2AGE O0 CAPITALBUDGETING 4ETOD2

• In te$&s of consistenc( +ith o+ne$s) +ealth &a6i&i3ation9 NP and IRR a$e#$efe$$ed o"e$ othe$ &ethods.

• La$e$ co&#anies tend to #$efe$ NP and IRR o"e$ the #a('ac* #e$iod&ethod.

• The #a('ac* #e$iod is still used9 des#ite its failins.

• The NP is the esti&ated added "alue f$o& in"estin in the #$o%ectK the$efo$e9this added "alue should 'e $eflected in the co&#an()s stoc* #$ice.

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:. CA2 0LO PRO8ECTION2

The oal is to esti&ate the inc$e&ental cash flo+s of the fi$& fo$ each (ea$ in the#$o%ect)s useful life.


1 - / 5 :

In"est&entOutla(

Afte$!Ta6O#e$atinCash 0lo+





F

Te$&inalNono#e$atin

Cash 0lo+

Total Afte$!Ta6 Cash 0lo+








INE2T4ENT OUTLA7

Start with Ca#ital e6#enditu$e

Subtract Inc$ease in +o$*inca#ital

Equals Initial outla(




A0TER!TA< OPERATING CA2 0LO

Start with 2ales

Subtract Cash o#e$atin e6#enses

Subtract De#$eciation

Equals O#e$atin inco&e 'efo$e ta6es

Subtract Ta6es on o#e$atin inco&eEquals O#e$atin inco&e afte$ ta6es

Plus De#$eciation

Equals Afte$!ta6 o#e$atin cash flo+

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TER4INAL 7EAR A0TER!TA<NONOPERATING CA2 0LO

Start with Afte$!ta6 sal"ae "alue

Add Retu$n of net +o$*in ca#ital

Equals Nono#e$atin cash flo+




0OR4ULA APPROAC

Initial outla( Outla( 0CIn" F NCIn" 2al F T>2al B? >@?

Afte$!ta6 o#e$atincash flo+

C0 >2 C D?>1 T? F D

C0 >2 C?>1 T? F TD

>?

>?

Te$&inal (ea$ afte$!ta6nono#e$atin cash flo+>TNOC0?

TNOC0 2alT F NCIn" T>2alT BT? >H?


0CIN In"est&ent in ne+ fi6ed ca#ital 2 2ales

NCIn" In"est&ent in +o$*in ca#ital C Cash o#e$atin e6#enses

2al Cash #$oceeds D De#$eciation

B Boo* "alue of ca#ital T Ta6 $ate



E<A4PLE; CA2 0LO ANAL72I2

2u##ose a co&#an( has the o##o$tunit( to '$in out a ne+ #$oduct9 the ita&in!Bu$e$. The initial cost of the assets is 1 &illion9 and the co&#an()s +o$*inca#ital +ould inc$ease '( 1 &illion du$in the life of the ne+ #$oduct. The ne+#$oduct is esti&ated to ha"e a useful life of fou$ (ea$s9 at +hich ti&e the assets+ould 'e sold fo$ : &illion.

4anae&ent e6#ects co&#an( sales to inc$ease '( 1- &illion the fi$st (ea$91@ &illion the second (ea$9 15 &illion the thi$d (ea$9 and then t$ailin to :&illion '( the fou$th (ea$ 'ecause co&#etito$s ha"e full( launched co&#etiti"e#$oducts. O#e$atin e6#enses a$e e6#ected to 'e of sales9 and de#$eciationis 'ased on an asset life of th$ee (ea$s unde$ 4ACR2 >&odified accele$ated cost$eco"e$( s(ste&?.

If the $eJui$ed $ate of $etu$n on the ita&in!Bu$e$ #$o%ect is and theco&#an()s ta6 $ate is /:9 should the co&#an( in"est in this ne+ #$oduct= h(o$ +h( not=

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Pieces;• In"est&ent outla( 1 1 11 &illion.

• Boo* "alue of assets at end of fou$ (ea$s .

! The$efo$e9 the : sal"ae $e#$esents a ta6a'le ain of : &illion.

! Cash flo+ u#on sal"ae : >: W ./:? : 1.: /.-: &illion.

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,ear *

Investment outlays0i6ed ca#ital 1.Net +o$*in ca#ital 1.

Total 11.




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,ear ! " # $

Annual after-ta o!eratin" cash flows

2ales 1-. 1@. 15. :.Cash o#e$atin e6#enses 5. 11-. H. /:.De#$eciation //.// 55.5: 15.1 .51

O#e$atin inco&e 'efo$e ta6es -.@ /.:: -.1H .:HTa6es on o#e$atin inco&e .H/ 1.-5 H.:- -.@@O#e$atin inco&e afte$ ta6es 1.5 -./1 1.@ 5.H/ Add 'ac* de#$eciation //.// 55.5: 15.1 .51 Afte$!ta6 o#e$atin cash flo+ /:. 5@.@ /-.5 1-./5




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,ear $

#erminal year after-ta nono!eratin" cash flows

Afte$!ta6 sal"ae "alue /.-:

Retu$n of net +o$*in ca#ital 1.

Total te$&inal afte$!ta6 non!o#e$atin cash flo+s 1/.-:





,ear * ! " # $Total afte$!ta6 cash flo+ 11. /:. 5@.@ /-.5 -:.:H

Discounted "alue9 at 11. /-.5 5.H -:.H 1.1

Net #$esent "alue .1:

Inte$nal $ate of $etu$n 11.@



@. 4ORE ON CA2 0LO PRO8ECTION2

De#$eciation Issues

Re#lace&entDecisions

Inflation




RELEANT DEPRECIATION

• The $ele"ant de#$eciation e6#ense to use is the e6#ense allo+ed fo$ ta6#u$#oses.

! In the United 2tates9 the $ele"ant de#$eciation is 4ACR29 +hich is a set of#$esc$i'ed $ates fo$ #$esc$i'ed classes >e..9 /!(ea$9 :!(ea$9 !(ea$9 and 1!(ea$?.

! 4ACR2 is 'ased on the declinin 'alance &ethod9 +ith an o#ti&al s+itch tost$aiht!line and half of a (ea$ of de#$eciation in the fi$st (ea$.

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E<A4PLE; 4ACR2

2u##ose a U.2. co&#an( is in"estin in an asset that costs - &illion and isde#$eciated fo$ ta6 #u$#oses as a fi"e!(ea$ asset. The de#$eciation fo$ ta6#u$#oses is >in &illions?;


,ear +C/4 /ate .epreciation

1 -. 5.

- /-. @5.

/ 1H.- /.5

5 11.:- -/.5

: 11.:- -/.5

@ :.@ 11.:-

Total 1. -.



PRE2ENT ALUE O0 DEPRECIATIONTA< 2AING2

• The cash flo+ ene$ated f$o& the deducti'ilit( of de#$eciation >+hich itself is anoncash e6#ense? is the #$oduct of the ta6 $ate and the de#$eciation e6#ense.

! If the de#$eciation e6#ense is 5 &illion9 the cash flo+ f$o& this e6#ense is5 &illion W Ta6 $ate.

! The #$esent "alue of these cash flo+s o"e$ the life of the #$o%ect is the

present value of tax savings from depreciation.

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PRE2ENT ALUE O0 DEPRECIATIONTA< 2AING2

Continuin the e6a&#le +ith the fi"e!(ea$ asset9 the co&#an()s ta6 $ate is /:and the a##$o#$iate $eJui$ed $ate of $etu$n is 1.The$efo$e9 the #$esent "alue ofthe ta6 sa"ins is ::.H &illion.

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(in millions)

$ear %A&'S 'ate e!reciation #a Savin"s

Present alue

of e!reciation#a Savin"s

1 -. 5. 15. 1-./

- /-. @5. --.5 1.:1

/ 1H.- /.5 1/.55 1.1

5 11.:- -/.5 .@ :.:1

: 11.:- -/.5 .@ :.1@ :.@ 11.:- 5./ 5./

-. @H.HH ::.H



CA2 0LO2 0OR A REPLACE4ENT PRO8ECT

• hen the$e is a $e#lace&ent decision9 the $ele"ant cash flo+s e6#and toconside$ the dis#osition of the $e#laced assets;

! Inc$e&ental de#$eciation e6#ense >old "e$sus ne+ de#$eciation?

! Othe$ inc$e&ental o#e$atin e6#enses

! Nono#e$atin e6#enses

• Qe(; The $ele"ant cash flo+s a$e those that chane +ith the $e#lace&ent.

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2PREAD2EET 4ODELING

• e can use s#$eadsheets >e..9 4ic$osoft E6cel? to &odel the ca#ital 'udetin#$o'le&.

• Useful E6cel functions;

! Data ta'les

! NP

! IRR

• A s#$eadsheet &a*es it easie$ fo$ the use$ to #e$fo$& sensiti"it( and si&ulationanal(ses.

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E00ECT2 O0 IN0LATION ON CAPITALBUDGETING ANAL72I2

• Issue; Althouh the no&inal $eJui$ed $ate of $etu$n $eflects inflatione6#ectations and sales and o#e$atin e6#enses a$e affected '( inflation9

! The effect of inflation &a( not 'e the sa&e fo$ sales as o#e$atin e6#enses.

! De#$eciation is not affected '( inflation.

! The fi6ed cost natu$e of #a(&ents to 'ondholde$s &a( $esult in a 'enefit o$ a

cost to the co&#an(9 de#endin on inflation $elati"e to e6#ected inflation.

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. PRO8ECT ANAL72I2 AND EALUATION

hat if +e a$e choosin a&on &utuall( e6clusi"e#$o%ects that ha"e diffe$ent useful li"es=

hat ha##ens unde$ ca#ital $ationin=

o+ do +e deal +ith $is*=

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4UTUALL7 E<CLU2IE PRO8ECT2IT UNEUAL LIE2

• hen co&#a$in #$o%ects that ha"e diffe$ent useful li"es9 +e cannot si&#l(co&#a$e NPs 'ecause the ti&in of $e#lacin the #$o%ects +ould 'e diffe$ent9and hence9 the nu&'e$ of $e#lace&ents 'et+een the #$o%ects +ould 'ediffe$ent in o$de$ to acco&#lish the sa&e function.

• A##$oaches

1. Dete$&ine the least co&&on life fo$ a finite nu&'e$ of $e#lace&ents andcalculate NP fo$ each #$o%ect.

-. Dete$&ine the annual annuit( that is eJui"alent to in"estin in each #$o%ectad infinitum >that is9 calculate the e0uivalent annual annuity5 or 2++?.




E<A4PLE; UNEUAL LIE2

Conside$ t+o #$o%ects9 P$o%ect G and P$o%ect 9 'oth +ith a $eJui$ed $ate of$etu$n of :;

hich #$o%ect should 'e selected9 and +h(=


End!of!7ea$Cash 0lo+s

7ea$ P$o%ect G P$o%ect 1 1

1 / /- / /H/ / 5

5 /

NP @./ @.1-



E<A4PLE; UNEUAL LIE2NP IT A 0INITE NU4BER O0 REPLACE4ENT2

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1 - / 5 : @ H 1 11 1-

P$o%ect G @./ @./ @./

P$o%ect @.1- @.1- @.1- @.1-

P$o%ect G; T+o $e#lace&entsP$o%ect ; Th$ee $e#lace&ents

NP of P$o%ect G; o$iinal9 #lus t+o $e#lace&ents 1./NP of P$o%ect ; o$iinal9 #lus th$ee $e#lace&ents -1.@H

E<A4PLE UNEUAL LIE2



E<A4PLE; UNEUAL LIE2EUIALENT ANNUAL ANNUIT7

Project G

P @./

N 5

I :

2ol"e fo$ P4T

P4T 1.

Project H

P @.1-

N /

I :

2ol"e fo$ P4T

P4T -.-:


The$efo$e9 P$o%ect is #$efe$$ed >hihe$ eJui"alent annual annuit(?.

DECI2ION 4AQING UNDER



DECI2ION 4AQING UNDERCAPITAL RATIONING

• hen the$e is ca#ital $ationin9 the co&#an( &a( not 'e a'le to in"est in all#$ofita'le #$o%ects.

• The *e( to decision &a*in unde$ ca#ital $ationin is to select those #$o%ectsthat &a6i&i3e the total net #$esent "alue i"en the li&it on the ca#ital 'udet.

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E<A4PLE; CAPITAL RATIONING

• Conside$ the follo+in #$o%ects9 all +ith a $eJui$ed $ate of $etu$n of 5;

hich #$o%ects9 if an(9 should 'e selected if the ca#ital 'udet is;

1. 1=

-. -=/. /=

5. 5=

:. :=

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Pro*ect Initial

+utlay ,P PI I''

One 1 - 1.- 1:T+o / / 1.1 1Th$ee 5 5 1.1

0ou$ : 5: 1.H :0i"e - 1: 1. :



E<A4PLE; CAPITAL RATIONING

Possi'le decisions;

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ud"et &hoices ,P &hoices ,P &hoices ,P

1 One -

- One - T+o 1:

/ One F 0i"e /: T+o 1:

5 One F T+o : Th$ee 5

: One F Th$ee @ 0ou$ 5: T+o F 0i"e 5:

Qe(; 4a6i&i3e the total net #$esent "alue fo$ an( i"en 'udet.

O#ti&al choices



RI2Q ANAL72I2; 2TAND!ALONE 4ETOD2

• 4ensitivity analysis in"ol"es e6a&inin the effect on NP of chanes in onein#ut "a$ia'le at a ti&e.

• 4cenario analysis in"ol"es e6a&inin the effect on NP of a set of chanesthat $eflect a scena$io >e..9 $ecession9 no$&al9 o$ 'oo& econo&icen"i$on&ents?.

•4imulation analysis >4onte Ca$lo anal(sis? in"ol"es e6a&inin the effect onNP +hen all unce$tain in#uts follo+ thei$ $es#ecti"e #$o'a'ilit( dist$i'utions.

! ith a la$e nu&'e$ of si&ulations9 +e can dete$&ine the dist$i'ution ofNPs.

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RI2Q ANAL72I2; 4ARQET RI2Q 4ETOD2

The $eJui$ed $ate of $etu$n9 +hen usin a &a$*et $is* &ethod9 is the $etu$n that adi"e$sified in"esto$ +ould $eJui$e fo$ the #$o%ect)s $is*.

! The$efo$e9 the $eJui$ed $ate of $etu$n is a $is*!ad%usted $ate.

! e can use &odels9 such as the CAP4 o$ the a$'it$ae #$icin theo$(9 toesti&ate the $eJui$ed $etu$n.

Usin CAP49r i ' . F Xi YE >' % ? ' . Z >1?

+he$er i $eJui$ed $etu$n fo$ #$o%ect o$ asset i

' . $is*!f$ee $ate of $etu$n

Xi 'eta of #$o%ect o$ asset i YE >' % ? ' . Z &a$*et $is* #$e&iu&9 the diffe$ence 'et+een the e6#ected

&a$*et $etu$n and the $is*!f$ee $ate of $etu$n

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REAL OPTION2

• A real option is an o#tion associated +ith a $eal asset that allo+s the co&#an(to enhance o$ alte$ the #$o%ect)s "alue +ith decisions so&e ti&e in the futu$e.

• Real o#tion e6a&#les;

! iming option6 Allo+ the co&#an( to dela( the in"est&ent

! 4izing option6 Allo+ the co&#an( to e6#and9 $o+9 o$ a'andon a #$o%ect

! Flexibility option6 Allo+ the co&#an( to alte$ o#e$ations9 such as chanin#$ices o$ su'stitutin in#uts

! Fundamental option6 Allo+ the co&#an( to alte$ its decisions 'ased onfutu$e e"ents >e..9 d$ill 'ased on #$ice of oil9 continued R[D de#endin oninitial $esults?

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ALTERNATIE TREAT4ENT2 0OR ANAL7\ING



ALTERNATIE TREAT4ENT2 0OR ANAL7\INGPRO8ECT2 IT REAL OPTION2

Use NP +ithout conside$in $eal o#tionsK if #ositi"e9the $eal o#tions +ould not chane the decision.

Esti&ate NP NP Cost of $eal o#tions F alue of

$eal o#tions.

Use decision t$ees to "alue the o#tions at diffe$entdecision %unctu$es.

Use o#tion!#$icin &odels9 althouh the "aluation of$eal o#tions 'eco&es co&#le6 Juite easil(.




CO44ON CAPITAL BUDGETING PIT0ALL2

• Not inco$#o$atin econo&ic $es#onses into the in"est&ent anal(sis• 4isusin ca#ital 'udetin te&#lates• Pet #$o%ects• Basin in"est&ent decisions on EP29 net inco&e9 o$ $etu$n on eJuit(• Usin IRR to &a*e in"est&ent decisions• Bad accountin fo$ cash flo+s

• O"e$head costs• Not usin the a##$o#$iate $is*!ad%usted discount $ate• 2#endin all of the in"est&ent 'udet %ust 'ecause it is a"aila'le• 0ailu$e to conside$ in"est&ent alte$nati"es• andlin sun* costs and o##o$tunit( costs inco$$ectl(


OTER INCO4E 4EA2URE2 AND ALUATION



. OTER INCO4E 4EA2URE2 AND ALUATION4ODEL2

• In the 'asic ca#ital 'udetin &odel9 +e esti&ate the inc$e&ental cash flo+sassociated +ith acJui$in the assets9 o#e$atin the #$o%ect9 and te$&inatin the#$o%ect.

• Once +e ha"e the inc$e&ental cash flo+s fo$ each #e$iod of the ca#ital#$o%ect)s useful life9 includin the initial outla(9 +e a##l( the net #$esent "alue o$inte$nal $ate of $etu$n &ethods to e"aluate the #$o%ect.

• Othe$ inco&e &easu$es a$e "a$iations on the 'asic ca#ital 'udetin &odel.

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ECONO4IC AND ACCOUNTING INCO4E

AccountinInco&e

• 0ocus on inco&e•

De#$eciation'ased on o$iinalcost

Econo&icInco&e

• 0ocus on cash

flo+ and chanein &a$*et "alue• De#$eciation

'ased on loss of&a$*et "alue

Cash 0lo+s fo$Ca#ital Budetin

• 0ocus on cash

flo+• De#$eciation

'ased on ta6'asis


ECONO4IC PRO0IT RE2IDUAL INCO4E



ECONO4IC PRO0IT9 RE2IDUAL INCO4E9 AND CLAI42 ALUATION

• 2conomic profit >2P? is the diffe$ence 'et+een net o#e$atin #$ofit afte$ ta6>NOPAT? and the cost of ca#ital >in &oneta$( te$&s?.

EP NOPAT ACC >1-?

• /esidual income >/'? is the diffe$ence 'et+een accountin net inco&e and aneJuit( cha$e.

! The eJuit( cha$e $eflects the $eJui$ed $ate of $etu$n on eJuit( >r e? &ulti#lied'( the 'oo* "alue of eJuit( >t !1?.

RIt NIt r et E1 >1:?

• Claims valuation is the di"ision of the "alue of assets a&on secu$it( holde$s'ased on clai&s >e..9 inte$est and #$inci#al #a(&ents to 'ondholde$s?.


E<A4PLE;



E<A4PLE;ECONO4IC 2. ACCOUNTING INCO4E

Conside$ the oofdstad P$o%ect aain9 +ith the afte$!ta6 cash flo+s as 'efo$e9#lus additional info$&ation;

hat is this #$o%ect)s econo&ic and accountin inco&e=


,ear ! " # $

Afte$!ta6 o#e$atin cash flo+ /:. 5@.@ /-.5 1-./5Beinnin &a$*et "alue >#$o%ect? 1. 1:. 1. 1H.

Endin &a$*et "alue >#$o%ect? 1:. 1. 1H. -.De't :. :. :. :.Boo* eJuit( 5.5 [email protected] :H.- @.@:4a$*et "alue of eJuit( ::. 5H.5 5.5 @.-

E<A4PLE;



E<A4PLE;ECONO4IC 2. ACCOUNTING INCO4E

2olution;


,ear ! " # $

Econo&ic inco&e 5. 5.@ /5.5 1/./5 Accountin inco&e -.-@ 1.@H 1/.@ .H/



RE2IDUAL INCO4E 4ETOD

• The $esidual inco&e &ethod $eJui$es;! Esti&atin the $etu$n on eJuit(K

! Esti&atin the eJuit( cha$e9 +hich is the #$oduct of the $etu$n on eJuit( andthe 'oo* "alue of eJuit(K and

! 2u't$actin the eJuit( cha$e f$o& the net inco&e.

RIt NIt r et 1 >1:?

+he$e

RIt Residual inco&e du$in #e$iod t

NIt Net inco&e du$in #e$iod t

r et 1 EJuit( cha$e fo$ #e$iod t 9 +hich is the $eJui$ed $ate of $etu$n on

eJuit(9 r e9 ti&es the 'einnin!of!#e$iod 'oo* "alue of eJuit(9 Bt 1




E<A4PLE; RE2IDUAL INCO4E 4ETOD2u##ose the Boat Co&#an( has the follo+in esti&ates9 in &illions;

The $esidual inco&e fo$ each (ea$9 in &illions;


Year 1 2 3 4

Net inco&e 5@ 5H :@ :@Boo* "alue of eJuit( 1 5 :ReJui$ed $ate of $etu$n on eJuit( 1- 1- 1- 1-

,ear ! " # $

Step 1

Start with Boo* "alue of eJuit( 1 5 :%ulti!ly by ReJui$ed $ate of $etu$n on eJuit( 1- 1- 1- 1-

Equals ReJui$ed ea$nins on eJuit( H 1 1 1

Step 2

Start with Net inco&e 5@ 5H :@ :@Subtract ReJui$ed ea$nins on eJuit( H 1 1 1Equals Residual inco&e / /H 5@ 5@



E<A4PLE; RE2IDUAL 4ETOD

• The #$esent "alue of the $esidual inco&e9 discounted usin the 1- $eJui$ed$ate of $etu$n9 is 1-@ &illion.

• This is an esti&ate of ho+ &uch "alue a #$o%ect +ill add >o$ su't$act9 ifneati"e?.




CLAI42 ALUATION

•The clai&s "aluation &ethod si&#l( di"ides the clai&s of the su##lie$s ofca#ital >c$edito$s and o+ne$s? and then "alues the eJuit( dist$i'utions.

! The clai&s of c$edito$s a$e the inte$est and #$inci#al #a(&ents on the de't.

! The clai&s of the o+ne$s a$e the antici#ated di"idends.




E<A4PLE; CLAI42 ALUATION

2u##ose the Po$tfolio Co&#an( has the follo+in esti&ates9 in &illions;

1. hat a$e the dist$i'utions to o+ne$s if di"idends a$e : of ea$nins afte$#$inci#al #a(&ents=

-. hat is the "alue of the dist$i'utions to o+ne$s if the $eJui$ed $ate of $etu$n is1- and the 'efo$e!ta6 cost of de't is =


7ea$ ! " # $

Cash flo+ 'efo$e inte$est and ta6es : H: H:Inte$est e6#ense 5 / - 1Cash flo+ 'efo$e ta6es @ - H/ H5

Ta6es / // / /O#e$atin cash flo+ 5@ 5H :@ :@

P$inci#al #a(&ents 11 1- 1/ 15




,ear ! " # $

Start with Inte$est e6#ense 5 / - 1

Add P$inci#al #a(&ents 11 1- 1/ 15

Equals Total #a(&ents to 'ondholde$s 1: 1: 1: 1:

Start with O#e$atin cash flo+ 5@ 5H :@ :@

Subtract P$inci#al #a(&ents to 'ondholde$s 11 1- 1/ 15

Equals Cash flo+ afte$ #$inci#al #a(&ents /: / 5/ 5-Multiply

by Po$tion of cash flo+ dist$i'uted : : : :Equals EJuit( dist$i'ution 1 1H -1 -1

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1. Dist$i'utions to O+ne$s;




-. alue of Clai&sP$esent "alue of de't clai&s :

P$esent "alue of eJuit( clai&s :H

The$efo$e9 the "alue of the fi$& 1H




CO4PARI2ON O0 4ETOD2

'ssue raditionalCapital7udgeting

2conomicProfit

/esidual'ncome

Claims1aluation

Uses netinco&e o$cash flo+=

Cash flo+ Cash flo+ Net inco&e Cash flo+

Is the$e aneJuit( cha$e= In the cost of

ca#ital

In the cost ofca#ital in

dolla$ te$&s

Usin the$eJui$ed $ate

of $etu$nNo

Based onactual

dist$i'utions tode'tholde$sand o+ne$s=

No No No 7es




H. 2U44AR7

•Ca#ital 'udetin is used '( &ost la$e co&#anies to select a&on a"aila'lelon!te$& in"est&ents.

• The #$ocess in"ol"es ene$atin ideas9 anal(3in #$o#osed #$o%ects9 #lanninthe 'udet9 and &onito$in and e"aluatin the $esults.

• P$o%ects &a( 'e of &an( diffe$ent t(#es >e..9 $e#lace&ent9 ne+ #$oduct?9 'utthe #$inci#les of anal(sis a$e the sa&e; Identif( inc$e&ental cash flo+s fo$ each$ele"ant #e$iod.

• Inc$e&ental cash flo+s do not e6#licitl( include financin costs9 'ut a$ediscounted at a $is*!ad%usted $ate that $eflects +hat o+ne$s $eJui$e.

• 4ethods of e"aluatin a #$o%ect)s cash flo+s include the net #$esent "alue9 theinte$nal $ate of $etu$n9 the #a('ac* #e$iod9 the discounted #a('ac* #e$iod9 the

accountin $ate of $etu$n9 and the #$ofita'ilit( inde6.




2U44AR7 >CONTINUED?

•The #$efe$$ed ca#ital 'udetin &ethods a$e the net #$esent "alue9 inte$nal$ate of $etu$n9 and the #$ofita'ilit( inde6.

! In the case of selectin a&on &utuall( e6clusi"e #$o%ects9 anal(sts shoulduse the NP &ethod.

! The IRR &ethod &a( 'e #$o'le&atic +hen a #$o%ect has a noncon"entionalcash flo+ #atte$n.

! The NP is the e6#ected added "alue f$o& a #$o%ect.

• e can loo* at the sensiti"it( of the NP of a #$o%ect usin the NP #$ofile9+hich illust$ates the NP fo$ diffe$ent $eJui$ed $ates of $etu$n.

• e can identif( cash flo+s $elatin to the initial outla(9 o#e$atin cash flo+s9

and te$&inal9 nono#e$atin cash flo+s.! Inflation &a( affect the "a$ious cash flo+s diffe$entl(9 so this should 'e

e6#licitl( included in the anal(sis.




2U44AR7 >CONTINUED?

• hen co&#a$in #$o%ects that ha"e diffe$ent useful li"es9 +e can eithe$ assu&ea finite nu&'e$ of $e#lace&ents of each so that the #$o%ects ha"e a co&&onlife o$ +e can use the eJui"alent annual annuit( a##$oach.

• e can use sensiti"it( anal(sis9 scena$io anal(sis9 o$ si&ulation to e6a&ine a#$o%ect)s att$acti"eness unde$ diffe$ent conditions.

• The discount $ate a##lied to cash flo+s o$ used as a hu$dle in the inte$nal $ateof $etu$n &ethod should $eflect the #$o%ect)s $is*.

! e can use diffe$ent &ethods9 such as the ca#ital asset #$icin &odel9 toesti&ate a #$o%ect)s $eJui$ed $ate of $etu$n.

• 4ost #$o%ects ha"e so&e fo$& of $eal o#tions 'uilt in9 and the "alue of a $ealo#tion &a( affect the #$o%ect)s att$acti"eness.

• The$e a$e "aluation alte$nati"es to t$aditional ca#ital 'udetin &ethods9includin econo&ic #$ofit9 $esidual inco&e9 and clai&s "aluation.

capital budgeting

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