Financial Management - Capital Budget

8/2/2019 Financial Management - Capital Budget

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Notes on Capital Budgeting

I. CAPITAL BUDGETING METHODS.A. Payback method. Number of years to recover the investment amount.1. Example:Project A Project B

Investment ($1000) ($1000)Year 1 $500 $100Year 2 400 200Year 3 300 300Year 4 200 400Year 5 100 500Year 6 10 600Year 7 10 0

2. Decision rule:Accept project if the payback years < years set by corporate policy3. Problems with payback method

a) Ignores income beyond payback period.b) Does not account for time value of money.

B. Net Present Value method. Find the present value of future cash flowsthen subtract the initial investment amount.1. Example:

Project C Project DInvestment ($1000) ($1000)

PV factor@ 10% PVYear 1 $500 .9091 =454.55 $100Year 2 400 .8264 =330.56 200Year 3 300 .7513 =225.39 300Year 4 100 .6830 = 68.30 400Year 5 10 .6209 = 6.21 500Year 6 10 .5645 = 5.65 600

PV = 1091 PV = 1404-Inv = 1000NPV = 91

2. Decision rule:If independent project: Accept project if NPV > 0

Reject project if NPV < 0If mutually exclusive project: Accept the project with the highest NPV

C. Internal Rate of Return (IRR): That rate of return which makes theNPV of the future cash flows equal to zero.


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1. Example: Use trial and error or your financial calculatorProject C

Investment ($1000)PV factor PV factor

@ 10% PV @ 15%Year 1 $500 .9091 =454.55 $500 .8696 = 434.80Year 2 400 .8264 =330.56 400 .7561 = 302.44Year 3 300 .7513 =225.39 300 .6575 = 197.25Year 4 100 .6830 = 68.30 100 .5718 = 57.18Year 5 10 .6209 = 6.21 10 .4972 = 4.97Year 6 10 .5645 = 5.65 10 .4323= 4.32

PV = 1091 PV = 1000-Inv = -1000 -Inv = -1000NPV = 91 $ 0

2.

Decision rule: If independent projects:Accept if IRR > opportunity cost of capitalReject if IRR < opportunity cost of capital

If mutual exclusive projects: Accept the project with the highest IRR.

3. Problems with IRR methods.a) Size problem if projects are mutually exclusive:

Project Large Project SmallInvestment ($1.0 million) ($1.00)Year 1 CF $1.25 million $1.50Using IRRUsing NPV@ 10% rate

b) Multiple solutions problem.Project

Investment: ($22)Yrs 1 4 +$15Yr 5 -$40

IRR = 6% and 28% Suppose opportunity cost of capital is 10%?

c) Reinvestment Assumption: The IRR implicitly assumes that allfuture cash flows from the project are reinvested at the IRR rate ofreturn. The NPV implicitly assumes that all future cash flows arereinvested at the opportunity cost of capital.

If projects are mutually exclusive, the IRR assumption will lead toconflicting decisions compared to the NPV.

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II. Capital Budgeting Issue - PROJECTS WITH DIFFERENT LIVES.A. Example:

Machine 1 (M1) M1* Machine 2 (M2)

Investment ($1000) ($1800)Years 1 6 $400 $400Year 6 ($1200)Year 7 12 $400 $400NPV @ 10% NPV(M1) =$742 NPV(M2) =$926

NPV(M1+M1*) = $1048

B. Main issue:1. The important point is that it is not the life of the machine that dictates the

investment decision, but the investment horizon of what the machine isused for. For example, if this machine is used to produce Pokemon cards,

we must decide on which machine to invest in based on how long weexpect the Pokemon craze to last.

2. Alternatively for a high tech firm, it is important to decide how long theirlatest product will be marketable before it becomes obsolete. For theinvestment decision we will consider the sale of the production machine atthe 3 year point or put it to other use.

3. An Alternative Method. Use EAC (Equivalent Annual Cost) to evaluatemachines with different lives.

EAC is defined as an annuity cash flow that is equivalent to the NPV of aproject. It is calculated as:

EAC = PV of cost / (PV of annuity at k% for the life ofmachine)

where k% is the opportunity cost of capital.

Annuity of the NPV(M1) = $1000 / (PV of annuity at 10% for 6 yrs)= $1000 / (4.355)= $229.62

Calculate the annuity of the NPV(M2) = $

Think of EAC as the RENTAL COST if you were to rent (or lease) themachine instead of purchasing it.

Choose the machine that is less costly.

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Try another problem:Machine A Machine B

Cost of machine $15 $10Cost to maintainIn year 1 $ 4 $ 6

In year 2 4 6In year 3 4 0

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III. INCREMENTAL CASH FLOW ANALYSIS FOR CAPITAL BUDGETING

A. Existing firm New productSales $10,000 $1,000

- CofGS 4,000 300

Gross Profits $ 6,000 $ 700- Operating Exp - 1,000 - 300- Depreciation Exp 1,000 - 200Operating Profits $ 4,000 $ 200

- Interest Exp ------- -----Profits Bef taxes $ 4,000 $ 200

Taxes (40%) -1,600 - 80PAT $ 2,400 $ 120

Incremental Cash Flow = PAT + Depreciation Exp= (1-T)[Sales-CoGS-OE-D] + D

= (1 - T)[Sales - CoGS-OE] - (1-T)D + D-D +TD +D

Incremental Cash Flow = CF= (1-T)[Sales - CoGS - OE] + TD

B. Additional Net Working CapitalExisting firm New product

Accounts Receivable $4,000 $ 100Inventory 5,000 600

Accounts Payable 6,000 300$3,000 $ 400

C. EXCLUDE: Research & Development, Test marketing, Survey, etc. that areSUNK COST or costs that are irreversible.

D. INCLUDE: Indirect (or incidental costs/benefits) effects that could arisebecause of the NEW PRODUCT.

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E. INCLUDE: Opportunity Costs such as opportunity cost of leasing land or

building if project is rejected.

1. Example:

WRONG WAY TO COMPARE is to look at before & after project.

Before Take Project After CF before vs afterFirm owns land Firm still owns land $0

2. CORRECT WAY TO COMPARE is with or without project:

Before Take Project After CF with ProjectFirm owns land Firm still owns land $0

Before Rejects Project After CF w/o

ProjectFirm owns land Firm sells land for $1mil $1 milIncremental CF = +$1 mil

3. Another example: EROSION

If SUN Microsystems introduces SUN4 it will erode the sale of SUN3.

Before Take on Sun4 After CF with SUN4Sun sells $1m SUN3 Sun sells $0.5 m SUN3 ($0.5 m)

Before Rejects Sun4 After CF without SUN4Sun sells $1m SUN3 Sun sells $0.5 m SUN3 ($0.5 m)

(Apollo's Domain4000) technologicaladvancement takes SUN3's mkt share)

Incremental CF = $ 0 m

4. KEY QUESTION: Will this cost/benefit exist only because of the Project? If your answer is NO then it is an irrelevant cost/benefit. If your answer is YES, then it is a relevant cost/benefit.

The cost/benefit can be directly attributable to the Project

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To answer the question above depends on:

Barriers to entry: How costly is it for competitors to enter the "new" market? Competition: How competitive is the market for the "new" product?

Substitutability: What other products can be substituted for the "new"product?

If Barriers are very costly then EROSION is probably attributable to the newProject.

If competition is fierce then EROSION is probably not attributable to the newProject.

If substitutability is easy, then EROSION is probably not attributable to thenew Project.

F. INCLUDE Real overhead costs but not Accounting Allocated Overhead costs.G. INCLUDE: EXCESS CAPACITY using the EAC method.1. Example 1:

Suppose Sun has a silicon compression machine (SCM) that is used tomanufacture Sun3. If Sun4 is produced, it will also use the SCM to produce itand will share the existing SCM. The SCM is a year old with a 5 year life andcost $100 million. Sun3 is using half of its SCM capacity and is expected to growat 15% annually. A new SCM could be purchased for $150 million today. Thenew SCM would have a 5 year life and the opportunity cost is 10%. IF Sun3 andSun4 are produced at the same time using the existing SCM, it will reach fullcapacity in 3 years. How should the excess capacity issue be resolved?

STEP 1: Calculate EAC for the old SCM:EAC = PV of cost/[PV of AN, 10%, 5]

STEP 2: Calculate EAC for the new SCM:

STEP 3: Calculate the number of years it takes to reach full capacity with SUN3only.

100 units (1+g)T = 200 units

STEP 4: Determine the incremental cost if Sun4 is adopted. Again use the "Withor without" principle.

Year 0 1 2 3 4 5Only Sun3Sun3&Sun4

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Cost to Sun4

2. Example 2:Suppose a billing company, Bill-4-You, uses Computer A to provide a billing

service to small businesses in a regional area. Computer A was purchased 2 yearsago at the cost of $100,000 and has 5 year life (3 years left). The firm currentlyuses about 1/3 of its capacity for their current clients. Bill-4-You is considering anew client who is a medium sized firm and would use much of Computer A. Infact, if the new client is accepted, the firm will reach full capacity on Computer Ain 3 years. Without the new client, the current clients of Bill-4-You will increaseits billings at a rate of 10% per year.

If a new computer is purchased to support a bigger client base, the firm wouldconsider purchasing Computer B at a cost of $300,000 with a 7 year life.Discount rate is 8%.

What are the relevant costs associated with the adoption of the new client.NOTE: The New Client is the New Project.

STEP 1:

STEP 2:

STEP 3:

STEP 4:

Year 0 1 2 3 4 5Only Old ClientsOld & New ClientsCost to New Client

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Financial Management - Capital Budget