Capital Budgeting

Economic concepts and finance decision-making tools BUS 219

Building Blocks of Knowledge

Time value of money a dollar in the future is worth less than a dollar in hand now Net present value
1. NPV = PV of cash flow benefits Investment cost 2. Accept project if NPV > $0

Financial Statements Cash is king

What is this slide show about?

Ingtegrates topics from several chapters of Corporate Finance

NPV Discounted cashflow analysis Project analysis

Capital Budgeting
Investment decisions involving capital assets (tangible property, including durable goods, equipment, buildings, installations, land) Capital refers to the fixed assets of an organization (factories, hospitals, schools, and their major equipment fit into this category),

Capital Budgeting (more)

A budget is a plan which explains the projected cash flows during some future period. A capital budget is therefore an outline of planed expenditures on fixed assets, and capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget

Capital Budgeting - Public Sector

Capital budgeting is done in the public sector too, although it is not always referred to as such. Economic analysis and investment analysis are synonymous terms that one my hear. Benefit-cost analysis and cost-effectiveness analysis play an important role in the process of capital budgeting

Capital budgeting decisions are among the most important ones made by managers and executives.

Importance
Results of investments in schools and hospitals continue for many years. Once these decisions are made, the organization loses some of its flexibility. Once a major piece of equipment is purchased, the organization is locked in to using it for the long term.

Importance (more)

Errors in the forecast need for big ticket assets can have serious consequences (LILCO-Shoreham) Imagine an office or hospital being built, or a school established, and then there is not enough demand to utilize the services. Conversely, what happens if not enough is spent. Inadequate capacity in a business, hospital or school can have disastrous results.

Importance (even more)

Timing is anotther reason that good capital budgeting is so essential. Essential assets need to be ready to come online when needed. Early arrivals cause extra expenses that will strain resources. Funding of such major projects involves very substantial expenditures. Large amounts of money are not available instantaneously in any organization, be it a large corporation, school district or the federal government.

Capital budgeting has become more effective, and more fun, during the past decade

Used to be math and manpower intensive, because the underlying theory needs a lot of calculations Nowadays, most modern organizations are able to use computers to transform data to information Capital budgeting used to take man years of work, mostly in manual calculations. Now capital budgeting is done in hours with spreadsheets

What was once a budget exercise becomes an analysis of policy (Peter Drucker)

Steps in the Capital Budgeting Process

1. Determine the economic life of the project or alternatives you are considering. 2. Estimate their Incremental Cash Flows 3. Determine the discount rate. 4. Calculate Net Present Value 5. Apply the appropriate criterion to arrive at an initial preference

More Steps in the Capital Budgeting Process

6. Do Sensitivity & Scenario Analysis 7. Interpret the results of the basic analysis and the sensitivity/scenario analysis, and make a decision. 8. If you decide to aquire the use of an asset, evaluate: lease versus buy 9. Check to make sure you can afford your decision by putting it in the organizations budget. 10. Implement & Verify your decision.

Capital Budgeting Decision making

Concepts you must understand to be able to participate:

incremental cash flows the time value of money and sensitivity analysis

Incremental Cash Flows Two Rules

Annual cash flow, and not accounting profits or costs, are to be used. Depreciation and the need for Working Capital are causes of major differences between profits and cash flow Only Incremental cash flows are relevant for evaluating investment projects. Only those cash flows that would result directly from a decision to accept a project are considered

Working Capital
The payroll needs to be paid before revenues from the days work are received Working capital is the cash you need to pay expenses before the benefits are realized

Taxes and Depreciation

Taxes are a fact of life, and need to be considered in all financial decisions Depreciation is an expense that is not a negative cash flow; to the contrary depreciation results in a tax shield (a positive cash flow) that offsets taxes to some extent

Incremental Cash Flows Example

a firm considering the establishment of a branch office in a newly developing section of a city Incremental cash flows will consist of the costs of investment and operating the new office, costs that it would not have been incurred unless the project was undertaken. It will also include the revenues derived from the business, benefits that would not have been realized otherwise.

Incremental Cash Flows Three conceptual problems

Sunk costs,
Opportunity costs and Externalities.

Sunk Costs
Sunk costs are cash outlays that have already been incurred and cannot be recovered regardless of any present or future decision. Sunk costs are not incremental costs and should not be included in capital budgeting analysis.

Sunk Cost Example

The firm and its branch office decision. Suppose it hired a consulting firm two years ago to do a site analysis. The $75,000 they paid is irrelevant, a sunk cost, because it cannot be recovered no matter whether or not they decide to build their new branch office.

Easier said than done

It may be psychologically impossible for policy makers to ignore sunk costs for future decisions, even though it is accepted practice in higher circles. There is a natural tendency to continue with a course of action, unable to see that it was incorrect, even when there is evidence to show the project is doomed to fail. The term used for this behavioral process is escalation of commitment

Opportunity costs

Consider the firm with the branch office decision. Suppose they own land upon which the branch could be built. Should they ignore the cost of the land because they will not have a cash outlay to acquire it? No, because if they dont use the land they could sell it, for let us say $100,000.

An opportunity cost is a benefit lost

Opportunity cost is the maximum worth of an asset among possible alternative uses Opportunity cost is thus a cash flow that could be generated from assets the organization already owns provided they are not used for the project in question

Externalities
Externality is an economic term, which comes from the idea that we should account for the direct effects, whether positive or negative, on someones welfare that arise as a by-product of some other persons or firms activity Synonyms are neighborhood, interactive or spillover effects

Externalities (more)
Consider the firms present customers who might use the new branch office. Business they do at the branch will reduce business at the main office. That effect needs to be accounted for in the analysis. Branch office incremental revenues should be reduced by the amount of decreased revenues at the main office, say $25,000/yr.

Summary - Economic Concepts for use in discounted cash flow analysis

Do use
Incremental Cash inflows and outflows External benefits/costs Opportunity costs

Do not include
Accounting profits Sunk costs

Time Value of Money

What do you do with future incremental cash flows of a project? Calculate their Net Present Value!

Start with displaying them on a time line

Example

Firm invests $500,000 in a new branch next year, estimates it would return a net* of $100,000 ($500,000 in revenues offset by $400,000 in expenses) annually beginning a year latter. Sunk costs are not included. $100 opportunity cost is added to the initial investment for a first year total cost of $600, 000. $25,000/yr. external cost of the reduced revenues at the home office should be accounted for.

*i.e. the effects of taxes and depreciation are included

Time Line: Incremental Cash Flows for the New Branch Office Project Year Cash Flow 0 1 2 75k 3 75k 4 75k 5 75k 6 75k 7 75k 8 75k 9 75k

($600k) 75k

Underlying Data & Calculations for the New Branch Office Project Investment $500k

Opportunity Cost 100k External Cost Operations Cost* Revenues Net Cash In (out) (600k) 25k 400k 500k 75k 25k 400k 500k 75k 25k 400k 500k 75k 25k 400k 500k 75k 25k 400l 500k 75k 25k 400k 500k 75k 25k 400k 500k 75k 25k 400k 500k 75k 25k 400k 500k 75k

*Includes effects of taxes and depreciation

The dilemma facing the firm

Do you invest something now with a promise of a return in the future? Its not a simple case of foregoing $600,000 and recovering $650,000($75,000 x 9) over the next 9 years. Dollars received in the future cannot be equated to dollars spent in the near term. Money in hand has more value than a like amount of money in the future because of the opportunity it represents. The challenge is how to account for this time value of money.

Calculating the Projects NPV

Determine the discount rate Calculate the present value of each years cash flow Sum PV of future cash flows, then subtract the investment to get NPV

Discount rates are estimates of an organizations cost of capital If you as an individual were going to invest in a project, the alternative use of your money would be the clue to your cost of capital. A firms cost of capital depends on where it would get the cash to fund the project.

Firms cost of capital

If it borrowed it, the cost of capital would be the after tax interest rate it pays on a loan or the bonds it issues. If the business sold more stock to raise the money, the cost of capital would be the rate of return the stockholders expect to get.

Cost of capital

If the project is funded with cash from the businesss accounts, then the cost of capital would be the estimated rate of return on alternative investments. Often, businesses get money from all three sources. When this is the case, they estimate their cost of capital by a weighted average calculation. (Chapter 12)

Riskier Projects > Higher Discount Rate

Weighted average cost of capital is a good discount rate for average risk projects Higher risk projects should use a higher than average cost of capital

NPV of the Firms Project

Year Net Cash Flow PV
Factor

$ 75 75 75 75 75 75 75 75 75 (600) K 1.000 .935 .873 .816 .763 .713 .666 .623 .582 .544 66 61 57 53 50 47 44 41

7% PV $ 70 @7% (600) NPV $ (111) K

Calculating NPV
Can use the Formula Tables (as done on the previous slide) Calculator Spreadsheets make it really easy

Making an Initial Decision

Follow a criterion, or decision rule. Which rule to follow depends upon the circumstances. If you are in business and your objective is to turn a profit and increase shareholders wealth, the rule is simple: you accept any project that has a positive net present value

Special Rule
If projects are mutually exclusive, then you choose among them by picking the one with the highest positive net present value Mutually exclusive projects are ones that would not be chosen together, like building a bridge and buying ferry boats to traverse the same route.

Sensitivity Analysis
Nothing is certain in the future. Since that is where the consequences of capital budgeting decisions occur, we must challenge the assumptions underlying our calculations. We know estimates are wrong. Its a matter of how wrong they have to be to cause us to make a bad decision.

Definition
Sensitivity analysis in general refers to a repetition of analysis using different values for uncertain factors. If a reasonable change in an assumed value results in a change in preference among choices, then the decision is said to be sensitive to that assumption or that variable

How to do what if

In capital budgeting, sensitivity analysis measures the effect of changes to a particular variable, say annual operating cost, on a projects present value All variables are fixed at their expected values, except one. That one variable is then changed, often by specified percentages, and the resulting effect on present value is noted

Sensitivity Analysis Routine

Spreadsheets and contemporary PC technology make the performance of sensitivity analysis a piece of cake. Excel is ideally suited for sensitivity analysis. Once a model is created, it is very easy to change the values of variables and obtain new results.

Usefulness

Identify those variables which potentially have the greatest impact on success or failure Helps policy makers focus attention on these variables that are probably most important. The sources of the estimates of these variables should be further scrutinized, and alternative sources sought.

Sensitivity Analysis
Above all else, it serves as a risk assessment tool If a reasonable change in an estimate causes the outcome to go from a success to a failure, then the decision is risky

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of changes in single variables (sales, costs, etc.) on a project. Scenario Analysis - Project analysis given a particular combination of assumptions.
Worst Case Scenario Best Case Scenario Most Likely Scenario

Summary

Capital budget decisions are among the most important ones a firm can make Steps. For each project:
1. 2. 3. 4. 5. 6. 7. Estimate economic life Estimate Incremental Cash Flows Determine the discount rate Calculate Net Present Value Order preference of all projects based on NPV Do Sensitivity & scenario analysis Interpret the results of the basic analysis and the sensitivity/scenario analysis, and make a decision. 8. Decide: lease or buy 9. Plan to implement what you can afford 10. Follow up, verify and adjust

Capital Budget Decision Process

Cost of Capital Criterion Determine Discount Rate NPV Initial Choice

Start

Discounted cash-flow analysis Determine Relevant Incremental Cash Flow s

Sensitivity & Scenario Analysis

Lease or buy assessts?

yes

Do the Project?

Accounting Projections (Income Statement)

End: decision

no