8 LECTURES & 9 INTRODUCTION TO NET PRESENT VALUE AND CAPITAL BUDGETING
Reading: Chapter 7, Section 7.1 Chapter 8, Sections 8.1-8.4 Homework: Online problems, supplemental readings, study for midterm. Objectives: Understand the Net Present Value Criterion and its importance in evaluating corporate investments Identify the information that is required to compute NPV Identify the relevant, incremental cash flows of an investment proposal Evaluate an investment proposal using the NPV criterion given a discount rate
WHAT IS CAPITAL BUDGETING?
Capital budgeting is the decision making process for investment decisions, i.e., deciding how much and what to invest in. The most important decisions a corporation can make involve the acquisition of long-term assets. (Sometimes called capital budgeting or strategic asset allocation.) In what lines of business or activities should we invest? What types of equipment should we acquire? Should we replace our plant or equipment? What other companies should be buy? To make these decisions, we apply the valuation principle and law of one price. What is the market value of the projects benefits? What are the costs? If the benefit is bigger than the cost, we do it. Net Present Value is a dollar measure of the market value of an investment's benefits less its costs. Put another way, the net present value is the amount by which an investment will increase the market value of the firm.
If a project has an NPV of $100,000, doing it would increase the market value of the firm by $100,000.
WHAT DOES NET PRESENT VALUE MEASURE?
The market value of all financial claims on a firm equals the present value of all current and future free cash flow. Free Cash Flow is the cash flow the firm generates that is available to pay out to all investors, including stockholders, bondholders, banks and other creditors.
Firm Value = FCF0 + FCF1 (1 + r1 )
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FCF2 (1 + r2 )
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FCF3 (1 + r3 )
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+ ...
Net present value measures the present value all of the changes in a firm's current and future free cash flow. means "change in" (Firm Value)= NPV = FCF0 +
FCF1 (1 + r1 )
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+
FCF2 (1 + r2 )
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+
FCF3 (1 + r3 )
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+ ...
FCF refers to incremental free cash flows.
(FCF represents all the changes in the firm's free cash flows that result from the investment.) r is the required return (or discount rate or cost of capital) r is the return that could be earned in the financial market for investments with the same risk
EXAMPLE
You own a company that operates 5 Arbys Roast Beef Sandwich shops in Seattle. The company generates free cash flow of $100,000 per year, and you expect to close your stores in 5 years. Today 1 2 3 4 5 100,000 100,000 100,000 100,000 100,000 100,000 If your discount rate is 8% per year, the value of your company is: 1 1 100,000 + 100,000 = 499,271 .08 .08(1.08) 5 You are considering opening a new Arbys for $55,000 today. It will add to cash flows by $20,000 over the next 5 years: Today -55,000 1 20,000 2 20,000 3 20,000 4 20,000 5 20,000
Projected Cash flows for the company after opening the new shop Today 45,000 1 120,000 2 120,000 3 120,000 4 120,000 5 120,000
Value of the company with the project:
1 1 45,000 + 120,000 = 524,125 5 .08 .08(1.08)
EXAMPLE (CONTINUED)
So, opening the new Arbys will increase the value of your company by $24,854 (=$524,125 - $499,271). Rather than revaluing the entire company based a new project, what we usually do is identify just the changes in cash flows due to the project and value those directly. If their value is positive, then the company is better off with the project:
1 1 NPVof project = 55,000 + 20,000 = 24,854 .08 .08(1.08)5
Thus, the NPV of the project is the change in the value of the firm that comes as a result of the project.
Decision rule based on NPV: Accept an investment if its NPV is positive Reject if its NPV is negative. Positive NPV means the project will increase the value of the firm; negative means it will decrease it.
SOME IMPORTANT POINTS ABOUT NPV
1. NPV is a dollar measure of the effect of an investment on the value of a business. a. NPV reflects all effects, both near term and in the distant future, of an investment. b. A positive NPV project adds value to the company, so you want to take all positive NPV projects and reject all negative NPV projects 2. The challenges of implementing NPV are: a. Forecasting incremental free cash flow (today) b. Evaluating whether forecasts make economic sense (Next time) c. Identifying option characteristics (also next time) d. Estimating the discount rate (after the mid-term). The discount rate reflects the risk of an investment. For now it will be given to you. 3. Net present value ignores the value of managerial flexibility. That is, NPV misses the value of options that managers have to expand, scale back, or abandon investment projects once they are undertaken. We will discuss this briefly next time, but to get a good understanding, you will need to take an advanced corporate finance class.
INCREMENTAL FREE CASH FLOWS
Incremental free cash flows are any and all changes in free cash flows caused by undertaking an investment. Like any economic decision we base our analysis on marginal (or incremental) benefits and costs. The definition of free cash flow helps us structure our analysis Changes in operating income (EBIT) -Changes in net working capital -Changes in capital spending +Proceeds for sale of project assets =Changes in Free cash flow We ignore cash flows associated with financing of the project: Ignore interest on debt used to purchase it Ignore dividends on any new stock issued to raise the funds We want to know the value of the project itself We are interested in the total cash flow the project generates Interest and dividend payments just determine how these cash flows are split between different classes of investors The value of the project is the present value of the cash flow it can generate for all investors If the present value of the cash the project generates exceeds the amount of investment it requires (i.e. its positive NPV), it will increase shareholder wealth under most financing arrangements. Think of buying a house. Do you want to know whether the total price of the house is reasonable, or just your down-payment? We will talk about financing decisions later in the class.
A MORE DETAILED LOOK AT THE COMPONENTS OF FREE CASH FLOW
Operating cash flow Revenues Operating expenses Be sure to include effects on revenues and operating costs in other parts of the company, but ignore interest Taxes Include the tax effects of depreciation but not depreciation itself Less Changes in net working capital include 1. sales and purchases on credit (accounts receivable and payable) 2. changes in inventories of materials and finished goods 3. reserves of cash
Incremental overhead or administrative costs Investment Purchases and sales of assets Include any tax effects of sales Opportunity cost of assets already owned that are employed and could be sold or redeployed to other uses. Important: Ignore sunk costs, i.e. costs already incurred and cannot be recovered. This would include assets already owned but that cannot be sold or redeployed for another purpose.
TAXES AND CAPITAL BUDGETING
Throughout our discussion of capital budgeting, taxes will be the part that makes things complicated. Because of tax laws, we have to worry about whether certain effects are taxable and how much tax they incur. One example is depreciation, which is a charge to earnings (a quasi-expense) that reduces taxes, but not an actual cash flow.
Another example is the sale of an asset. Whenever you sell an asset, you pay taxes on any capital gain from the sale. Uncle Sam defines capital gain as:
Capital gain = Selling Price - Book Value. (where Book Value = Purchase Price - Accumulated Depreciation)
A TYPICAL PROFILE OF CASH FLOWS
Initial outlays or cash flows Purchase and installation of assets Changes in net working capital Training expenses net of tax effects Sale or disposal of replaced assets net of tax effects Intermediate cash flows Revenues minus expenses net of tax effects Less changes in net working capital (subtract non-cash revenue, inventory purchases, and add back non-cash expenses) Changes in overhead expenses net of tax effects Depreciation tax shields Terminal cash flows
Proceeds from sale of assets net of tax effects Costs of clean up or disposal net of tax effects Recovery of working capital Or, if youre valuing a business, the terminal cash flow can be computed as a growing perpetuity.
SOME POTENTIAL PITFALLS
Include changes, not levels, of net working capital Include the recovery of net working capital at the termination of project a Ignore costs that are not incremental (i.e., sunk costs and precommitted expenditures) Ignore financing cash flows such as interest payments and dividends Include only overhead costs that are incremental to the project Include the opportunity cost of owned assets that are employed in a project that could be redeployed to another project or sold Treat inflation consistently (i.e., discount nominal cash flows by nominal discount rates) Include the tax effects of the sale of assets Include effects on the sales and costs of production of related products or services of the company Ignore depreciation charges, but include the tax effects of depreciation Always ask the "with vs. without" question!
WHAT IS A RELEVANT CASH FLOW?
Suppose you are deciding whether to invest in a new manufacturing plant. You own the land and buildings that will be used, but existing buildings must be demolished. Which of the following are incremental cash flows? Market value of land and existing buildings. Costs of demolition and clearing land. Cost of building a new access road put in last year. Lost earnings from other products due to managers' time spent on the new plant Portion of the cost of leasing the president's plane Future depreciation of the new plant Initial investment on inventories and raw materials Payments already made for engineering design of the new plant.
EVALUATING PROPOSALS
Investment in new machine = $8,000 Increase in revenues = $1000 Reduction in annual operating costs = $3,000 per year for 4 yrs Change in net working capital = $0 Market value of machine in 4 yrs = $1,000 Straight line depreciation for 4 yrs = $2,000/ yr Tax rate = 0.34 Required rate of return = 0.10 Incremental cash flows Operating cash flows: which will be determined by revenues, operating costs, depreciation and taxes. Initial investment = $8,000 Proceeds from sale of equipment = Selling price - (selling price-book value)()
Year 0 + Revenues - Costs - Depr = EBIT - Taxes = EBIAT Add Back Depr - Capital Expend = Net Cash Flow
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CAPITAL BUDGETING EXAMPLE
The JoePa Electric Co. is considering a contract to manufacture a specialized switch. The contract calls for the company to deliver 3000 switches per year for four years at a price of $30 per switch (paid on delivery). Producing the switch will require use of some existing equipment and investment of $100,000 in new equipment. The variable cost of the switch will be $15 per switch throughout the life of the contract. The existing equipment that would be used is already fully depreciated. If used to make switches, it will not require any maintenance expenditures but it will be worthless at the end of the contract. The company has no other use for the equipment but could sell it now for $1000. The new equipment that would be used on the switch contract requires no maintenance expenditures but will be depreciated to zero on a straight-line basis over 4 years. At the end of four years, this equipment can be sold for $10,000. The cost of capital for this project is 10%. JoePa Electrics tax rate is 33%. Should JoePa take the switch contract? Assume that all cash flows except the initial equipment-related flows occur at the ends of years 1 through 4.
JOEPA ELECTRIC EXAMPLE
CAPITAL BUDGETING EXAMPLE FROM A PAST MIDTERM You are considering the following project: The project will last for 3 years. Based on $15,000 in market research, you believe that each year you will have revenues of $230,000 (and expenses of $100,000). The project will require new equipment valued at $80,000. This equipment will be depreciated to 0 using the straightline method over a five-year life. You plan to sell the equipment for $20,000 in year 3. Working capital at the firm will have to rise to $20,000 from the current level of $10,000 immediately. It will go down to $15,000 in year 2 and to $10,000 in year 3. Forecast all of the incremental cash flows for this project and compute its net present value based on a discount rate of 10%. Your tax rate is 35%.
Room to work the Capital Budgeting Practice
For next time:
1) Do the homework 2) Study for midterm 3) Work on practice midterms 4) Do the supplemental readings for the next lecture, posted on the web.
Note on Working Capital
Basically, what's going on with working capital is that you're tying up money in the operations of the company. The important point is that you're tying it up in a form that does not bear interest. For example, you have to hold additional cash in a demand account that does not bear interest or you have to buy additional raw materials to keep on hand for production. As these raw materials sit on the shop floor waiting to be used, you are losing the use of the money tied up in them--that is, if you buy $1000 of iron and it sits on the shop floor for a week before being used, you have lost the interest you could have earned on that $1000. When we deal with working capital in our capital budgeting analyses, we are simply accounting for the time value of money and the lost interest on money tied-up in the production of our product. Since additions to working capital are really just shifts in assets (you transform money, which is an asset, into iron, which is also an asset, and then eventually get all of your money back when you finish the project, changes in working capital do not affect your taxes. For that reason, we deal with them last, after we have handled taxes. An important point to keep in mind is that we only care about CHANGES in working capital. If our working capital is $10 million before the project and stays at $10 million throughout the project, then our project has no effect on working capital, does not tie-up any more money that we already were, and therefore, working capital is irrelevant for our analysis. However, if our project will require working capital to increase from $10 million to $12 million right away, then in year 0, we account for a cash outflow of $2 million, which is what it will take for us to increase our investment in working capital. Let's say the project lasts for 5 years and working capital remains at the $12 million level until the end of the project. Then, since the only other CHANGE in working capital occurs in the 5th year when it decreases back down to $10 million, we only have one other cash flow related to working capital: +$2 million in year 5 when we get our money back out of working capital. Now let's think about what we have. We have a $2 million outflow in year 0 and a $2 million inflow in year 5. Thus, the total effect on our NPV of these working capital-related cash flows is the time value of money (the lost interest): -2M + 2m/(1+r)^5. Two key points: 1. WC doesn't affect taxes, so handle it below the tax line in your analysis. 2. We only care about changes, not levels, of working capital. The cash flows caused by these changes are equal and opposite to the changes (if working capital goes up by $5M, it is a negative $5M cash flow.)
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Note on Accounts Receivable
Accounts Receivable (and Accounts Payable, for that matter) figure into working capital. Often, a new project will create a change in accounts receivable. In general, what's going on is that you book revenues when the sales are made, but you may not actually get the cash flow until later. Since we are always concerned with cash flow in capital budgeting, we have to make an adjustment for the fact that some of the dollars we've listed as revenues haven't actually entered the building yet. You pay taxes when revenues are booked, so the fact that you haven't received the money yet doesn't affect your taxes. Let's take a simple example. Assume that you book $10 million in revenues, and that 50% of those revenues ($5 million) have not actually been received as payment yet (you have billed your customers, but they haven't paid yet). Let's also say that you incurred $2 million in costs, and $0.5 million in depreciation. Your tax rate is 40%. You also have a $0.5 million decrease in inventory this quarter. Revenues - Costs - Depreciation = Op Income - Tax (40%) = After Tax Income + Add Back Depr + CF from Chg. in WC =( +0.5 from inventory - 5 in Accounts Receivable ) = FCF 10 2 0.5 7.5 3 4.5 0.5 -4.5
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So, just like inventory, an increase in accounts receivable increases working capital, yielding an offsetting decrease in cash flows. In this case, you're subtracting $5M from your After Tax Income to account for the fact that $5M in revenues have not yet been received. Like any other part of working capital, each period, you will only be concerned with CHANGES in accounts receivable-the net amount that it goes up or down as last quarter's bills are paid and this quarter's revenues are billed.
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