Advanced Managerial Finance - Chapter 12-14 - Capital Budget Decision Criteria

Project Considerations

-Cash Flow Effect on the new project -Changes in Net Operating Working Capital -Interest charges are not included -Evaluating the incremental cash flows. This is the difference between CF w/project and CF w/o the project -Sunk Costs: This is an outlay to the project that has already been accounted for -Opportunity Cost: Values of assets that the company already owns and is part of a project calculation -Externalities: impacts on other areas of the company or outside the firm. -Expected inflation

Options to Consider

-Timing Options: Running the project at a different time -Growth Options: measuring the increase in capacity and profitability -Abandonment Options -Flexibility Options: changing elements of an existing project

decision tree

A decision tree shows how different decisions during a project's life can affect its value. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

flexibility option

A flexibility option is the option to modify operations depending on how conditions develop during a project's life, especially the type of output produced or the inputs used. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 565). Cengage Learning. Kindle Edition.

growth option

A growth option occurs if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible. These include: (1) options to expand the original project's output, (2) options to enter a new geographical market, and (3) options to introduce complementary products or successive generations of products. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

option value

A project may have an option value that is not accounted for in a conventional NPV analysis. Any project that expands the firm's set of opportunities has positive option value. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 599). Cengage Learning. Kindle Edition.

project's cash flow

A project's cash flow, or project's net cash flow, is different from its accounting income. Project cash flow reflects: (1) cash outlays for fixed assets, (2) sales revenues, (3) operating costs, (4) the tax shield provided by depreciation, and (5) cash flows due to changes in net working capital. A project's net cash flow does not include interest payments, because they are accounted for by the discounting process. If we deducted interest and then discounted cash flows at the WACC, this would double-count interest charges. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

NPV 2

A project's true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 517). Cengage Learning. Kindle Edition.

abandonment option

An abandonment option is the ability to discontinue a project if the cash flow turns out to be lower than expected. It reduces the risk of a project and increases its value. Instead of total abandonment, some options allow a company to reduce capacity or temporarily suspend operations. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 565). Cengage Learning. Kindle Edition.

investment timing option

An investment timing option involves the possibility of delaying major expenditures until more information on likely outcomes is known. The opportunity to delay can dramatically change a project's estimated value. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Analysis Categorization

As discussed when talking about cost of capital analysis is costly in terms of time and capital.

market risk

Assuming the CAPM holds true, market risk is the most important risk because (according to the CAPM) it is the risk that affects stock prices. However, usually it is difficult to measure a project's market risk. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

PI:

Basically the PV of cash flows over the initial cost showing the relative profitability of any project

Payback/Discounted Payback:

Calculating the number of years to recover the initial investment.

Cannibalization

Cannibalization is an important type of externality that occurs when a new project leads to a reduction in sales of an existing product. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

Capital budgeting

Capital budgeting is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones that managers must make. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

Capital rationing

Capital rationing occurs when management places a constraint on the size of the firm's capital budget during a particular period. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 517). Cengage Learning. Kindle Edition.

Corporate risk

Corporate risk is important because it influences the firm's ability to use lowcost debt, to maintain smooth operations over time, and to avoid crises that might consume management's energy and disrupt its employees, customers, suppliers, and community. Also, a project's corporate risk is generally easier to measure than its market risk. Because corporate and market risks usually are generally correlated, corporate risk can often serve as a proxy for market risk. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Decision

Decision trees are commonly used to illustrate how firms make business decisions that depend on the actions of rival firms. A decision tree has boxes that contain points that represent when firms must make the decisions contained in the boxes. What are these points called?

NPV:

NPV: Discounting the total cash flows, minus the initial costs, providing an analysis of impact to net income

Externalities:

Externalities: impacts on other areas of the company or outside the firm.

marginal cost of capital

Flotation costs and increased risk associated with unusually large expansion programs can cause the marginal cost of capital to increase as the size of the capital budget increases. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 517). Cengage Learning. Kindle Edition.

opportunity costs sunk cost

In determining incremental cash flows, opportunity costs (the cash flows forgone by using an asset) must be included, but sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the firm) should also be reflected in the analysis. Externalities can be positive or negative and may be environmental. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

investment timing options

Many investment timing options, growth options can be valued using the Black-Scholes call option pricing model. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 600). Cengage Learning. Kindle Edition.

Monte Carlo simulation

Monte Carlo simulation is a risk analysis technique that uses a computer to simulate future events and thereby estimate a project's profitability and riskiness. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

real options

Opportunities to respond to changing circumstances are called real options or managerial options because they give managers the option to influence the returns on a project. They are also called strategic options if they are associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called "real" options because they involve "real" (or "physical") rather than "financial" assets. Many projects include a variety of these. Embedded options that can dramatically affect the true NPV. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Opportunity Cost:

Opportunity Cost: Values of assets that the company already owns and is part of a project calculation

discounted payback

The discounted payback is similar to the regular payback except that it discounts cash flows at the project's cost of capital. It considers the time value of money, but it still ignores cash flows beyond the payback period. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

Real options

Real options are opportunities for management to respond to changes in market conditions and involve "real" rather than "financial" assets. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 599). Cengage Learning. Kindle Edition.

Project decisions are not created equal and choices are not equal - so they are categorized:

Replacement needed - considered essential to operations Replacement to reduce costs Expansion of existing products or markets Expansion into new markets or products Contraction decisions (cost reduction) Safety/Environmental/Risk Mgmt Misc Asset Acquisition Mergers or Strategic Acquisition Some require more detailed analysis and others very little

Risk

Risk is important because it affects the discount rate used in capital budgeting; in other words, a project's WACC depends on its risk. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

Scenario analysis

Scenario analysis is a risk analysis technique in which the best- and worstcase NPVs are compared with the project's base-case NPV. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Assessing the risk

Sensitivity Analysis Scenario Analysis Monte Carlo Simulation - a scenario analysis that covers all the scenarios

Sensitivity analysis

Sensitivity analysis is a technique that shows how much a project's NPV will change in response to a given change in an input variable, such as sales, when all other factors are held constant. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

IRR:

The discount rate that makes the aggregate PVs' equal the initial cost - or setting the NPV to zero

Project risk and capital budgeting generally have three categories of risk:

Stand alone risk Corporate risk Market risk/Beta risk

Stand-alone risk

Stand-alone risk is easier to measure than either market or corporate risk. Also, most of a firm's projects' cash flows are correlated with one another, and the firm's total cash flows are correlated with those of most other firms. These correlations mean that a project's stand-alone risk generally can be used as a proxy for hard-to-measure market and corporate risk. As a result, most risk analysis in capital budgeting focuses on stand-alone risk. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Independent projects

The NPV and IRR methods make the same accept/reject decisions for independent projects, but if projects are mutually exclusive, then ranking conflicts can arise. In such cases, the NPV method should generally be relied upon. It is possible for a project to have more than one IRR if the project's cash flows change signs more than once.

internal rate of return (IRR)

The internal rate of return (IRR) is defined as the discount rate that forces a project's NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

incremental cash flows

The most important (and most difficult) step in analyzing a capital budgeting project is estimating the after-tax incremental cash flows the project will produce. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

net present value (NPV) method

The net present value (NPV) method discounts all cash flows at the project's cost of capital and then sums those cash flows. The project should be accepted if the NPV is positive because such a project increases shareholders' value. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

profitability index (PI)

The profitability index (PI) is calculated by dividing the present value of cash inflows by the initial cost, so it measures relative profitability—that is, the amount of the present value per dollar of investment. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

payback period

The regular payback period is defined as the number of years required to recover a project's cost. The regular payback method has three flaws: It ignores cash flows beyond the payback period, it does not consider the time value of money, and it doesn't give a precise acceptance rule. The payback method does, however, provide an indication of a project's risk and liquidity because it shows how long the invested capital will be tied up. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

risk-adjusted discount rate

The risk-adjusted discount rate, or project cost of capital, is the rate used to evaluate a particular project. It is based on the corporate WACC, a value that is increased for projects that are riskier than the firm's average project and decreased for less risky projects. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 564). Cengage Learning. Kindle Edition.

Five possible procedures for valuing real options:

There are five possible procedures for valuing real options: (1) DCF analysis only, and ignore the real option; (2) DCF analysis and a qualitative assessment of the real option's value; (3) decision-tree analysis; (4) analysis with a standard model for an existing financial option; and (5) financial engineering techniques. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 600). Cengage Learning. Kindle Edition.

Sunk Costs:

This is an outlay to the project that has already been accounted for

MIRR:

This represents the situation where a project may have multiple IRRs due to having more than one cash outflow during the cash flow period

modified IRR (MIRR)

Unlike the IRR, a project never has more than one modified IRR (MIRR). MIRR requires finding the terminal value of the cash inflows, compounding them at the firm's cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 516). Cengage Learning. Kindle Edition.

stand-alone risk, corporate risk (or within-firm risk) market risk (or beta risk)

We discuss three types of risk: stand-alone risk, corporate risk (or within-firm risk), and market risk (or beta risk). Stand-alone risk does not consider diversification at all; corporate risk considers risk among the firm's own assets; and market risk considers risk at the stockholder level, where stockholders' own diversification is considered. Brigham, Eugene F.; Daves, Phillip R.. Intermediate Financial Management (Page 563). Cengage Learning. Kindle Edition.

Cash Flow Analysis

You need to know: Project cost of capital Initial cost Annual cash flows Are projects independent or mutually exclusive (different ways of getting the same result)

Screening Projects -six quantitative protocols :

six quantitative protocols : Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Profitability Index (PI) Regular Payback Discounted Payback The most commonly used criteria is NPV, but good CFOs/Analysts use all the above criteria