Budgeting Capital (Chapter 10) Introduction In this topic we will consider an important issue for corporations. If you look at a company, it is made up of a group of projects. A company will run a project until it matures or for a certain number of years and then shut it down. Afterwards, it will start a new project and so on. The company may also run several projects at the same time. If you look at General Motors, for example, each of GM's products is a project. A particular model of Chevrolet is a project that would run for few years, then it would be redesigned or discontinued. The company needs to find a way to evaluate these projects and decide whether they are acceptable or not. That's what we will be doing in this topic. We will look at three ways for evaluating projects, we will see the advantages and disadvantages of each of these methods, and decide on which is the best method to use. We will also look at the ability of these methods to rank projects. Under what circumstances would the company need to rank projects from best to worst? Mutually exclusive projects Mutually exclusive projects are projects that cannot be implemented at the same time. If one of these projects is accepted, the others are automatically rejected. Mutually exclusive means choosing one would also exclude the others. This is the main reason we need to rank projects. Limited resources The statement has been made that a company cannot accept a lot of projects because of limited resources, especially financing. This is not an accurate idea. We do have finite resources and the entire economy. If all the companies in the economy wanted funds, they would face a situation of limited funds or limited resources. However, as far as any one company is concerned, resources are not limited. Companies have to find funds for new projects because companies would not have a lot of cash uninvested. If a company has a lot of cash un-invested, it is a bad sign. Companies should utilize all of their assets. Therefore, when the company needs money for a new project, it will have to borrow or sell stock. So, the idea of limited resources is not the true limitation. However, there are times when companies find that funds are scarce. In a recession, banks are very careful about lending because a company may not be able to repay the loan. Similarly, if investors in the stock market are not optimistic about a company's prospects, they will not buy the company's shares. This situation occurred after September 11, 2001.
Capital Budgeting Techniques and Project Analysis Cash flows The methods described below depend on cash flows for their analysis. Cash flow is defined as net income plus depreciation. CF = NI + Depreciation Net income is profit after all expenses, including taxes, have been paid. Depreciation is added because it is money from revenues that the company gets to keep. It is called a non-cash expense because the company did not write a check for this expense. Cash flows are generally measured in years since these are long term projects. Positive cash flows mean the company is earning a profit. Negative cash flows mean the company is spending money or losing money. Payback period The payback period is defined as the number of years needed to recover the initial investment. For example, if the project requires $1000 to start and it produces $250 per year, then the payback is four years. This is how this method is calculated. Decision rule 1) If that payback is shorter than the threshold that is determined by the company the project is acceptable, otherwise the project is not acceptable. For example, if we only accept projects with a payback less than five years then the project in our example is acceptable. On the other hand, if the threshold is three years the project in our example is not acceptable. 2) When ranking projects, the shortest payback period is best and the longest is worst. Advantages of this method This method is easy and quick. This is not a true advantage because when the company is investing money, it should worry about the value of the investment other than using an easy technique. Disadvantages of this method 1) It ignores time value of money. As you can see in the example, we did not consider interest rates or the cost of raising funds. These are major flaws in finance.
2) It favors short-term projects. Because this method considers cash flows up to the payback period, it favors projects that have high cash flows at the beginning stages of a project's life. 3) It ignores cash flows after the payback period. This method ignores cash flows after the payback period regardless of their size and timing. This means there is no measure of profitability. 4) Arbitrary threshold. As you see in the example, when the threshold of five years or three years is given, there was no analysis, the number was given arbitrarily. This is not acceptable. A threshold should be based on financial analysis. This method should not be used for evaluating projects. It is included in the notes to warn you against using it. You may encounter individuals who think that this is a viable method because it's easy. However, accuracy is much more important than ease of use. This method has been suggested as a good initial filter for pharmaceutical companies because patents on medicines expire within a set the number of years. Afterwards the profitability of the medicine drops a very quickly. Penicillin was discovered in the 1940s, aspirin was invented in the 1960s or `70s, and both are still profitable today. It's a good thing this method was not used when penicillin and aspirin were being evaluated. Therefore, we will not use this method for evaluating projects. This method should not be used because it provides an unreliable accept or reject decision and an unreliable ranking of projects. Net present value (NPV) The net present value of a project equals the present value of cash inflows minus the present value of cash outflows. When calculating present values, the cost of capital should be used as the discount factor. The NPV equation is
NPV CF0
1 r
CF1
1
1 r
CF2
2
1 r
CF3
3
...
1 r n
CFn
CF0 is the initial investment in the project. It a negative number reflecting the funds the company is spending to invest in the project. CF1...n are the cash flows in the remaining years of the project. In the first years of the project, they may be positive or negative. Eventually they should become positive or else the project will be rejected. To illustrate this method, consider the following example: is the following project acceptable? We are considering a project that requires a $1,000 initial investment, the project would produce a cash flow of $350 per year for five years, and the required return or cost of capital is 15 percent. Solution:
NPV = PV(cash inflows) PV(cash outflows) PV(cash inflows) = 1,173.25 PV(cash outflows) = -1,000 NPV = 1,173.25 1,000 = 173.25 Since the NPV is positive, the project is acceptable. If the company implements this project, the company's value would increase by $173.25. Decision rule If the net present value is positive, the project is accepted. If the net present value is 0, the project is still acceptable but the manager is indifferent in this case. If the net present value is negative, the project is rejected. The reason for this rule is because the net present value measures the change in the company's value due to accepting the project. So if it is positive, value will increase by the positive amount, if it is zero the size of value will not change, and if it is negative, value would be reduced. When ranking projects, the highest net present value is best and the lowest is last. This method provides a reliable accept or reject decision and provides reliable ranking. Therefore, this is the method that should be used for evaluating and ranking projects. Advantages of this method 1) It uses cost of capital as the discount factor. This assumes that cash flows from the project would be at reinvested the cost of capital not at the project's rate of return. This is a realistic assumption. The reason is that the project may have a rate of return that is higher than the cost of capital. 2) This method considers time value of money. When calculating net present value of all the cash flows, this method uses interest rate calculations. 3) 4) This method considers all cash flows so the profitability of the project is included. This method does not favor short time on long-term projects.
Disadvantages of this method The NPV method favors larger projects over smaller projects. A $1 billion project will have larger cash flows and a larger NPV than a $1 million project. This does not mean it is necessarily better. The NPVs of both projects can be adjusted by calculating the Profitability Index. See the presentation in the text for a description of this method. Internal rate or return (IRR)
The internal rate of return is defined as the discount factor that makes the NPV of a project equal to zero. It is the return to the investment in the project. Look at the equation for the NPV above. Set the NPV equal to zero and solve for r. Unfortunately, it is not possible for solve for r directly. It is calculated by using trial and error. Calculators and spreadsheets must be used to find the IRR. To illustrate the calculations, consider the following example: what is the IRR for the project shown above for NPV? Using a calculator or spreadsheet, the answer is 22.11 percent. A sample spreadsheet has been provided and will be described below. Decision rule 1) If the IRR is greater or equal to the required return, then the project is acceptable. If the IRR is less than the required return, then the project is not acceptable. In our example, if we compare the IRR with the required return, we would see that the IRR is greater than the required return. Therefore, the project is acceptable. 2) When ranking projects, the highest IRR is best and the lowest is worst.
Advantages of this method 1) 2) 3) This method is easy to understand. It is intuitive. It considers all the cash flows so again, profitability is included. Since it is related to the NPV method, it also considers the time value of money.
Disadvantages of this method 1) The main disadvantage of this method is that it produces a percentage, not a measure of the change in wealth. In our example, it produced 22.11 percent, not a dollar amount. 2) Multiple IRRs. In cases were the cash flows from a project change sign more than once, this method would produce multiple IRRs. For example, when a project is first implemented, the initial investment is a negative cash flow. Afterwards, you would get years of positive cash flows. Say, a few years down the road the company performs major maintenance on the plant. This will cause the cash flows to become negative for a year and then go back to being positive. These multiple changes in the direction of cash flows cause the multiple IRRs. Look at the pattern of these cash flows. Project A Project B + + + + + one IRR one IRR
Project C
-
+
+
-
multiple IRRs
3) Ranking. This method can reliably accept or reject projects, but cannot reliably rank them. To illustrate this idea consider these two one-year projects. The required return is 10%: Project A Initial investment Return IRR NPV 10,000 15,000 50% $3,636 Project B 100,000 120,000 20% $9,090
Both the IRR and the NPV accept both projects. Therefore, they are both acceptable. However, when ranking the projects, the IRR method favors project A while the NPV method favors project B. Which do you prefer? The answer is project B. Project B increases the company's value by $9,090 while project A increases the value by $3,636. If the goal is to maximize the value of the company, then project B will do a better job. This concludes the review section of the notes. The next section deals with the topic to be covered for this section of the course. The Investment Decision A company can be looked at as a group of projects. For example, Toyota can be viewed as the Camry project, the Corolla project, and the other models. Someone in the firm has to decide what project is acceptable or not. The change in the value of a firm due to accepting a project is equal to the net present value of the project. Therefore, we should only accept projects with an NPV greater than zero. The value of the project = PV (operating cash flows that occur from accepting the project). NPV = PV (cash inflow) PV (cash outflow) Use the cost of capital (WACC) as the required return to calculate the NPV. The change in the value of the firm = NPV Calculating NPV involves three steps: 1Forecast cash flow 2Estimate the cost of capital 3Calculate the NPV Cash flow analysis
Consider only net cash flows and ignore financial costs such as interest expense. The reason interest expense is ignored is because the cost of capital takes care of it. If it were included in the cash flow analysis, it would be counted twice. The cash flow may be estimated as follows. Sales COGS Depreciation EBIT EBT Taxes at 40% NI 1,000 (600) (100) 300 300 (120) 180
Cash flow = 180 + 100 = 280 Numerical example This example is shown in the accompanying spreadsheet. A project requires $100,000 as an initial investment. This will be depreciated straight line to zero over the 5 year life of project. Annual sales are expected to be $60,000. Total operating expenses are $5,000 annually. The tax rate is 40%. The interest expense is $5,000. The required rate is 15%. Is the project acceptable? The annual cash flows for this project are the following. Revenues Operating expenses Depreciation EBT Taxes at 40% Net income 60,000 5,000 20,000 35,000 14,000 21,000
Cash flow = NI + Depreciation Cash flow = 20,000 + 21,000 = 41,000 The NPV and IRR can now be calculated. Important Note on Calculating NPV and IRR in Excel Look at the formula to calculate NPV in the spreadsheet. Excel discounts the first cash flow listed in the formula which is usually CF0 and which should not be discounted. Therefore, the formula has to be adjusted to calculate NPV accurately. Use the NPV function to calculate the present value of CF1...n , then program Excel to subtract CF0 after that.
For some strange reason, the IRR function does not have this problem. Look at the formula. The cash flows are listed in order with no separate listing for CF0. The 10% in the formula is the initial guess which Excel uses to find the IRR. It is not necessary to include the 10% guess in the formula. The default value is 10 percent. The number is in the formula to show the formal method of programming the IRR function. Other considerations Sunk cost Usually there is an amount of money that is spent before the start of a project. This amount is spent on research and development to design the product plus some funds are used for market research to estimate the demand for the product. These funds are not included in the analysis since they are sunk costs. They do not depend on the decision to go ahead with the project or not. The only cash flows that should be included in the analysis are those cash flows that depend on the decision to go ahead with the project or not. Erosion The impact of the sales of the new product on sales of existing products. For example, we forecast that our new product will sell 10,000 units at a price of $50 each. We also forecast that we will lose 1,000 units of sales from the existing product at $40 each because some existing customers will switch in addition to getting new customers. If COGS are 60% of sales, what is the EBIT ? Sales = (10,000 x 50) (1,000 x 40) = COGS = 0.6 x 460,000 = EBIT or operating earnings Uncertain cash flows Calculate the certainty equivalent. Forecasted annual cash flows are as follows: Probability 20% 70% 10% Annual cash flow 10,000 15,000 6,000 460,000 (276,000) 184,000
Certainty equivalent is the weighted average = (0.2 x 10,000) + (0.7 x 15,000) + (0.1 x 6,000) = $13,100 So we use $ 13,100 as the annual cash flows.