Capital Budgeting

Process of purchasing assets whose returns are expected to continue beyond 1 year

1) Identify Projects that could expand shareholder value 2) Estimate project's future cash flows 3) Evaluate cash flows and accept/reject using "decision rules"

Capital Budgeting Steps

Mutually Exclusive Projects

Only one of several potential projects can be chosen (accept one project means you cannot accept others)

Independent Projects

Accepting or rejecting one project does not affect the decision of other projects

Contingent Projects

Accepting one project requires acceptance of an additional project

NPV Decision Rule for Independent Projects

Accept if NPV > 0

NPV Decision Rule for Mutually Exclusive Projects

Accept highest NPV > 0

Shareholders receive gain above required return

What does a Positive NPV mean for shareholders?

Destruction of Shareholder wealth

What does a Negative NPV mean for shareholders?

Internal Rate of Return (IRR)

Discount rate that forces NPV to equal zero

Net Present Value

Measures present value of project (i.e. value created for shareholders)

Profitability (i.e. rate of return) for each dollar invested in project

What does IRR measure?

Accept >= Cost of Capital

IRR Decision Rule for Independent Projects

Project return satisfies investor's required return

If IRR >= r, ?

Project return doesn't satisfy investors required returns

IF IRR < r, ?

Accept highest IRR >= Cost of Capital

IRR Decision Rule for Mutually Exclusive Projects

Payback Period

How long it takes to recover project's initial investment

Shorter payback period = more efficient project

What does a shorter payback period say about the efficiency of the project?

- Easy to understand - Good Measure of liquidity

Payback Period Pros

- No set criteria on what acceptable payback period - Ignores time value of money - May ignore large cash flows (positive or negative) after payback period

Payback Period Cons

- Uses all project cash flows - Properly discounts cash flows at the cost of capital - Shows change in value for shareholders

Net Present Value Pros

- Can be difficult to explain to some audiences - Sensitive to forecasted cost of capital - Does not consider impact of capital rationing

Net Present Values Cons

- Easy to communicate to others - Reflects rate of return for each dollar invested - Does not depend on accuracy of the cost of capital

Internal Rate of Return Pros

- Does not distinguish between investing and financing - Can produce multiples internal rates of return - Assumes cash flows are reinvested at IRR - Ignores scale of the project (i.e. project's magnitude)

Internal Rate of Return Cons

1. Generate project proposals 2. Estimate future cash flows 3. Evaluate future cash flows (NPV, IRR, Payback Period)

What are the steps of capital budgeting?

Accounting Income

• Total revenues minus total expenses • Governed by "accrual accounting"

Revenue Recognition Principle

Recognize revenue in period it's earned

Matching Principle

Match expenses to period when revenues are recognized

Free Cash Flows

• Cash flow available for distribution to all investors • Measures actual cash flows

Incremental Cash Flows

Cash flow with the project minus Cash flow without the project

Financing Costs

Cash Flows paid to investors - Interest to debtholders - Dividends to shareholders

Sunk Costs

Cash flows that occurred before today • Costs are incurred regardless of project decision • Examples include R&D, market surveys, previous contracts

Opportunity Cost

Value form gives up by accepting project

Positive side effects - increase cash flows to the rest of the firm

How kind of side effects do complementary projects have on the rest of the firm?

Negative side effects - decrease cash flows to the rest of the firm ("cannibalization")

How kind of side effects do substitute projects have on the rest of the firm?

Op. CFs – Cap. Exp. – ΔNWC + Salvage Value – Opp. Costs +/– Side Effects

Free Cash Flows = ?

Capital Expenditures

Represent investments in long-term assets - Sustain productive capacity and provide growth

Net Working Capital (NWC)

Represents firm's use of current assets and current liabilities

Salvage Value

Represent cash flows from disposing of assets

- Uncertainty about a project's future profitability - Future cash flows are only estimates, not guaranteed

What does "risk" mean in capital budgeting?

Sensitivity Analysis

- Shows how change in one variable affects NPV, IRR - Each variable is fixed except one - Answers "what if" questions

Weaknesses of Sensitivity Analysis

- Says nothing about the likelihood of change in a variable - Ignores relationships among variables

Scenario Analysis

Examines several possible situations (usually worst, bad, average, good, best) and provides a range of possible outcomes (can calculate expected outcome, volatility of outcomes)

Weaknesses of Scenario Analysis

- Only considers a few possible outcomes - Assumes inputs are perfectly correlated

Simulation Analysis

• Computerized version of scenario analysis that uses continuous probability distributions • Computer selects values for each variable based on given probability distributions • NPV and IRR are calculated • Process is repeated many times (1,000 or more) • End result: Probability distribution of NPV and IRR based on sample of simulated values

Weaknesses of Simulation Analysis

• Difficult to specify probability distributions and correlations • If inputs are bad, output will be bad: “Garbage in, garbage out” • Requires large computational power

Risk Analysis Conclusions for Sensitivity, Scenario, and Simulation Analysis

• Do not provide a decision rule • Do not indicate whether project's return is sufficient for its risk • Ignore diversification • Measure stand-alone risk (may not be most relevant risk)

Weighted Average Cost of Capital

Represents a firm's average cost of borrowing

1. Determine Value of Operations 2. Determine Value of Firm 3. Determine Value of Common Equity 4. Determine Stock Price

What are the steps of FCF valuation?