Capital Budgeting
Advantages of Internal Rate of Return
1. It incorporates the timing of cash flows 2. It will give the correct accept/reject decision for a single conventional investment
Advantages of the payback measure
1. It is easy to understand 2. It can serve as a control. A large payback period can act as a warning signal
Why is accounting breakeven useful?
1. Like payback period, accounting breakeven is relatively easy to calculate and explain 2. Managers are often concerned with the contribution a project will make to the firm's total accounting earnings 3. A project that just breakeven on an accounting basis loses money in a financial or opportunity cost sense
Disadvantages of Profitability Index
1. May lead to incorrect decisions in comparisons of mutually exclusive investments
Advantages of the NPV approach
1. NPV incorporates the timing of cash flows 2. NPV gives the theoretically correct accept/reject specification on an individual investment 3. NPV can be used to compare two or more mutually exclusive investments
Issues Relating to Relevant Cash Flows
1. Sunk Costs 2. Opportunity Costs 3. Side Effects 4. Net Working Capital 5. Financing Costs
Advantages of Profitability Index
1. Closely related to NPV, generally leading to identical decisions 2. Easy to understand and communicate 3. May be useful when available investment funds are limited
Disadvantages of the payback measure
1. It ignores the timing of cash flows. For example, the following investment has a payback period equal to 1 but if r>0 the NPV<0 t=0 -2000 t=1 +2000 2. It ignores the cash flows after the payback period. Does not consider the total stream of cash flows.
Managerial Options
1. Option to expand 2. Option to abandon 3. Option to wait Opportunities that managers can exploit if certain things happen in the future
Average Accounting Return (AAR)
Amount of profit, or return, an individual can expect based on an investment made. There is more than one way that Average Accounting Return can be defined but it is usually calculated by dividing some measure of average net income over the life of the project by some measure of average book value of assets over the life of the project. Fairly inaccurate? Use another method to evaluate the projects. Ignores Time Value of Money and... ?
Sunk Costs
Cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision
The Cash Breakeven Point
Cash breakeven occurs when operating cash flow is 0. The cash breakeven point is thus: Q = FC/(P-v) FC = total fixed osts P= price per unit v= variable cost per unit A project tat always just breaks even on a cash basis never pays back, has an NPV that is negative and equal to the initial outlay, and has an IRR of -100 percent Operating CF = 0
Breakeven Analysis
Crucial variable for a project is sales volume. Break even analysis is a popular and commonly used tool for analyzing the relationship between sales volume and profitability. "How bad do sales ahve to get before we actually begin to lose money?"
Scenario Analysis (Type of Forecasting Risk)
Determination of what happens to NPV estimates when we ask what if questions Best case and worst case scenarios Optimistic and Pessimistic scenarios Let all the different variables change but let them take on only a few values
Crossover Rate
Discount rate at the Crossover Point For discount rates less than the crossover rate, one investment has a higher NPV. For discount rates greater than the crossover rate, the other investment has the higher NPV
Internal Rate of Return (IRR)
Discount rate which sets the NPV of a set of cash flows equal to zero... such that NPV=0 Graphically, the internal rate of return is the discount rate where the net present value profile cuts the x-axis. Discount rate is determined by the risk of specific project.
Economic Value Added (EVA)
EVAt = [Return on Invested Capitalt - Cost of Capitalt] x Invested Capitalt-1 = NOPATt - [WACCat,t x Invested Capitalt-1] where NOPAT: Net operating profits after tax divided beginning of year capital WACCat : After tax weighted average cost of capital Invested capital: all the cash raised from investors or retained from earnings to fund new investments in the business since the company's inception Alternative definition from Petroleum Chemicals: EVA = X(1-tc) - [WACCat x Capital] where X = EBIT (earnings before interest and taxes) tc = corporate tax rate
Discounted Payback
For a conventional investment, discounted payback is defined to be the time when the sum of the present values of all the preceding cash inflows equals the initial expenditure
Payback
For a conventional investment, payback is the time when the sum of all the preceding cash inflows equals the initial expenditure.
Net Present Value Profile
Graph of an investment's net present value as a function of various discount rates. Discount rate on x axis NPV on y axis If it is difficult to choose a discount rate, the profile makes it clear that the investment is desirable as long as the opportunity cost of funds is greater than or equal to zero and less than the IRR
Operating Leverage
High fixed costs Low variable costs = High Operating Leverage Fixed costs act like a lever in the sense that a small percentage change in operating revenue can be magnified into a large percentage change in operating cash flow and NPV DOL is the degree of operating leverage
When to accept a conventional investment?
If the IRR is greater than the firm's opportunity cost of capital (hurdle rate), the investment should be accepted. The investment has a positive NPV
Intuition of NPV
If the NPV>0, the project earns a higher return than the discount rate. i.e. if the discount rate is 10%, and the project earns 12%, the NPV >0 The appropriate discount rate is what an asset of similar risk outside the firm would earn - that is the discount rate is the opportunity cost. So if NPV>0, the invested capital earns more inside the firm than could be earned on that money in a project of similar risk outside the firm This is the scenario justifying retaining capital inside the firm vs paying the money out to stockholders via a cash dividend or share repurchase
Option to Expand
If there is a truly positive NPV projects, then there is an obvious consideration. Can we expand the project or repeat it to get an even larger NPV? Static analysis assumes that the scale of the project is fixed. We implicitly assume no expansion or price increase is possible... This underestimates the NPV
Sensitivity Analysis (Type of Forecasting Risk)
Investigation of what happens to NPV when only one variable is changed Variation of scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe if NPV estimate turns out to be very sensitive to small changes, then the forecasting risk associated with that variable is high Good for pinpointing where forecasting error will do the most damage but does not tell us what to do about possible errors Let only one variable change, but we let it take on many values
Loan Type Projects
Investment is only acceptable if IRR is less than the hurdle rate (discount rate) IRR is the cost of financing Opposite of conventional projects
Cash Flow Patterns
Investments should have three basic cash flow patterns a. Conventional (-+++): an expenditure followed by a series of cash inflows b. Loan (+---): a receipt of funds followed by a series of cash outflows c. Non-Conventional (-++- or +--+): at least two sign changes
Sources of Positive NPV Projects
Monopoly rents: the largest source of positive NPVs - profits above those necessary to keep resources employed in an endeavor that accrue as the result of being the only one able or allowed to do something Look for: 1. economies of scale Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs are spread out over a larger number of goods 2. product differentiation 3. cost advantages 4. access to distribution channels 5. favorable government policy
Accounting Breakeven (Breakeven Analysis)
Most widely used measure of break even The sales level that results in zero project net income Include depreciation in calculating expenses here even though depreciation is not a cash outflow which is why this is an accounting breakeven Project net income = (Sales - Variable Costs - Fixed Costs - Depreciation) x (1-Tax Rate) Net income = 0 = (S-VC-FC-D)x(1-T) (S-VC-FC-D) = 0 Q = (FC+D)/(Price -variable cost per unit)
Side Effects
Negative spillover Erosion: the cash flows of a new project that come at the expense of a firm's existing projects Relevant only when the sales would not otherwise be lost. Sales lost as a result of launching a new product anyway might be lost anyway because of future competition Positive spillover
Net Working Capital
Non-Cash, relevant working capital: current assets - current liabilities increases of working capital = use of cash decreases of working capital = source of cash (loans)
Option to Abandon
Option to scale back or even abandon a project. Underestimate the NPV if we assume that the project must last for some fixed number of years, no matter what happens in the future.
NPV Crossover Point
Point where the NPV profiles of 2 mutually exclusive projects corss
Forecasting Risk (Projected vs Actual Cash Flows)
Possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk
Profitability Index (PI)
Present value of a project's cash inflows divided by the present value of that project's cash outflows PI > 1 -> NPV is positive PI = 1 -> NPV is zero PI < 1 -> NPV is negative PI gives a measure of bang for the buck but CANNOT be used to choose among mutually exclusive investments - larger scale project might have a lower PI but a larger NPV
Opportunity Costs
Relevant, empty space is not an opportunity cost The most valuable alternative that is given up if a particular investment is undertaken
Net Present Value (NPV)
Sum of the present values of all the investment cash flows. The NPV of the investment equals the present value of cash inflows net of the present value of the cash outflows. If NPV > 0 , the investment is acceptable since it could be financed by borrowing with the loan repaid out of future cash flows. An amount equal to the NPV would be left over to contribute to profit above capital costs. Aside from estimation of cash flows, the main complexity of NPV is the choice of the appropriate discount rate (r)
Contingency Planning
Taking into account the managerial options implicit in a project
Option to Wait
We do not have to take a project immediately. Value of the option to wait is the difference in NPVs. Just because a project has a negative NPV today doesnt mean that we should permanently reject it.
Accounting Breakeven Point
When net income is 0. Operating cash flow is equal to depreciation when net income is 0, so the accounting break even point is Q = (FC+D)/(P-v) FC = total fixed osts P= price per unit v= variable cost per unit A project that always just breaks even on an accounting basis has a payback exactly equal to its life, a negative NPV, and an IRR of zero Net income = 0
The Financial Break-Even Point
When the NPV of the project is 0. The Financial breakeven point is thus Q = (FC+OCF*)/(P-v) FC = total fixed osts P= price per unit v= variable cost per unit Where OCF* is the level of OCF that results in a zero NPV. A project that breaks even on a financial basis has a discounted payback eqaul to its life, a zerp NPV, and an IRR just equal to the required return NPV = 0
Financing Costs
do NOT include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets of the project not of cash flow to creditors Goal is to compare cash flow from a project to the cost of acquiring that project in order to estimate NPV. Particular mixture of debt and equity a firm chooses to use in financing a project is a managerial variable
Stock's single period rate of return
r = (D1 + S1 - S0)/S0 Can be manipulated to show that the rate of return is the same as the internal rate of return of a single period investment in the stock.
Disadvantages of Internal Rate of Return
1. The use of internal rate of return to evaluate investments requires the choice of a hurdle rate 2. Even if only positive discount rates are considered, the IRR for a non-conventional investment might not be unique. i.e. If CF0=-1000, CF1=+2300, CF2=-1320 , both .10 and .20 are internal rates of return. And the investment is only acceptable if the firms opportunity cost of capital is between 10% and 20% 3. IRR is not an acceptable method to use to choose among mutually exclusive investments 4. The IRR adds nothing to an NPV analysis and in some cases could lead to incorrect decisions
Simulation Analysis (Type of Forecasting Risk)
A combination of scenario and sensitivity analysis Let all the items vary at the same time we have to consider a very large number of scenarios Result is many NPV estimates that we summarize by calculating the average value and some measure of how spread out the different possibilities are. Same problem as scenario analysis, once we have results, no simple decision rule tells us what to do
What should be the economic objective of a firm?
A firm should evaluate investments on the basis of prospective cash flows. Cash flows will differ with regard to timing and to riskiness