chapter 6 capital budgeting - Foreign Trade University

capital budgeting

1. CHAPTER 6 CAPITAL BUDGETING Nguyen Thu Hang

2. Capital Budget and Capital budgeting A capital budget lists the projects and investments that a company plans to undertake during the coming year. To determine this list, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting.

3. Outline Investment Decision Criteria Forecasting FCF Estimating incremental evenue , cost and earnings Forecasting FCF Some special projects Weighted Average Cost of Capital (WACC) Determining cost of capital Cost of equity Cost of debt Project based cost of capital Risk Analysis of Capital Investments

4. Reading CFA Corporate Finance, Level 2, Reading 23- Capital Budgeting Basic Principles of Capital Budgeting Investment decision criteria Cash flow projections Project Analysis and evaluation Berk-DeMarzo , Ch8, 18

5. The capital Budgeting process Generating Ideas: from anywhere, from the top or the bottom of the organization, from an departments or from outside  Most important. Analyzing individual proposals: gathering the information to forecast cash flows for each projects and then evaluating the projects profitability. Planning the capital Budget: fitting within the company’s overall strategies Monitoring and Post-auditing: actual results are compared to predicted results and any differences must be explained Re f: CFA L2, Corporate Finance, p. 6

6. Replacement projects . Expansion projects . New product/market development projects . Mandatory projects. Other projects (R&D,…). I. Categories of Investment Projects

7. Projects may be Independent . Mutually Exclusive . Dependent . Categories of Investment Projects

8. Basic Principles of capital budgeting Decisions are based on cash flows. Timing of cash flows is crucial. Cash flows are based on opportunity costs Cash flows are analyzed on an after-tax basis Financing costs are ignored Ref: CFA L2, Corporate Finance, pp. 8-10

9. Some detailed steps Forecasting FCFF (Forecasting earnings, determining FCFF) Identifying cost of capital Determining investment rules (NPV, IRR, PI, PB) Making decisions

10. Some key concepts Sunk cost (chi phí chìm ) Opportunity cost (chi phí cơ hội ) Incremental cash flow ( dòng tiền tăng thêm ) Externality ( ngoại tác ), VD cannibalization Unlimited fund Capital rationing ( giới hạn nguồn vốn ) Ref: CFA 2016, L2, Vol3, p.7

11. Sunk cost A sunk cost is one that has already been incurred. You cannot change a sunk cost. Today’s decisions, on the other hand, should be based on current and future cash flows and should not be affected by prior, or sunk, costs . Ref: CFA. 2016 CFA Level II Volume 3 Corporate Finance .

12. Opportunity cost An opportunity cost is what a resource is worth in its next-best use. If a company uses some idle property, what should it record as the investment outlay: the purchase price several years ago, the current market value, or nothing? If you replace an old machine with a new one, what is the opportunity cost? If you invest $10 million, what is the opportunity cost?

13. Incremental Cash flow An incremental cash flow is the cash flow that is realized because of a decision: the cash flow with a decision minus the cash flow without that decision.

14. Externality An externality is the effect of an investment on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. If possible, these should be part of the investment decision. Sometimes externalities occur outside of the company. An investment might benefit (or harm) other companies or society at large, and yet the company is not compensated for these benefits (or charged for the costs). Ref: CFA. 2016 CFA Level II Volume 3 Corporate Finance

15. Cannibalization Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.

16. Investment Decision Criteria Net Present Value (NPV) Investment rule Internal Rate of Return (IRR) Investment rule Profitability Index (PI) Payback rule (PB)

17. NPV IRR PI I

18. Example Researchers at Fredrick’s Feed and Farm have made a breakthrough. They believe that they can produce a new, environmentally friendly fertilizer at a substantial cost savings over the company’s existing line of fertilizer. The fertilizer will require a new plant that can be built immediately at a cost of $250 million. Financial managers estimate that the benefits of the new fertilizer will be $35 million per year, starting at the end of the first year and last in forever, as shown by the following timeline:

19. NPV Investment Rule Take the alternative with the highest NPV. A stand-alone project: Accept the project if its NPV is positive.

20. The NPV Profile

21. IRR Investment Rule Take any investment opportunity where the IRR exceeds the opportunity cost of capital. The internal rate of return investment rule is applied to single, standalone projects within the firm, when all of the project’s negative cash flows precede its positive cash flows .

22. Pitfall 1: Delayed Investments John Star, the founder of SuperTech , the most successful company in the last 20 years, has just retired as CEO. A major publisher has offered to pay Star $1 million upfront if he agrees to write a book about his experiences. He estimates that it will take him three years to write the book. The time that he spends writing will cause him to forgo alternative sources of income amounting to $500,000 per year. Considering the risk of his alternative income sources and available investment opportunities, Star estimates his opportunity cost of capital to be 10%.

23. Pitfall 2: Multiple IRRs Star has informed the publisher that it needs to sweeten the deal before he will accept it. In response, the publisher offers to give him a royalty payment when the book is published in exchange for taking a smaller upfront payment. Specifically, Star will receive $1 million when the book is published and sold four years from now, together with an upfront payment of $550,000. Should he accept or reject the new offer?

24. Pitfall 3: Nonexistent IRR After protracted negotiations, Star is able to get the publisher to increase his initial payment to $750,000, in addition to his $1 million royalty payment when the book is published in four years.  N o IRR exists; that is, there is no discount rate that makes the NPV equal to zero T he IRR rule provides no guidance whatsoever.

25. Example

26. Problem

27. The payback rule The payback investment rule states that you should only accept a project if its cash flows pay back its initial investment within a prespecified period. Payback period: the amount of time it takes to pay back the initial investment, Accept the project if the payback period is less than a prespecified length of time—usually a few years. Otherwise, reject the project.

28. Example Assume Fredrick’s requires all projects to have a payback period of five years or less. Would the firm undertake the fertilizer project under this rule? It will not be until year 8 that the initial investment will be paid back ($35 * 8 = $280 million). Because the payback period for this project exceeds five years, Fredrick’s will reject the project.

29. The payback rule Required rate of return= 12 %. Payback period? Discounted payback period? 1 2 3 4 5 -500 200 200 200 250 250 I II . CÁC Example

30. Payback Rule The payback rule is not as reliable as the NPV rule because:  I t ignores the project’s cost of capital and the time value of money. It ignores cash flows after the payback period. It relies on an ad hoc decision criterion (what is the right number of years to require for the payback period?) This rule is typically used for small investment decisions.

31. NPV Rule and Mutually Exclusive Investments

32. NPV Rule and Mutually Exclusive Investments When projects are mutually exclusive, we need to determine which projects have a positive NPV and then rank the projects to identify the best one. Pick the project with the highest NPV . Because the NPV expresses the value of the project in terms of cash today, picking the project with the highest NPV leads to the greatest increase in wealth.

33. IRR and Mutually Exclusive Investments Picking one project over another simply because it has a larger IRR can lead to mistakes. When projects differ in their scale of investment, the timing of their cash flows, or their riskiness, then their IRRs cannot be meaningfully compared.

34. Differences in Scale Would you prefer a 500% return on $1, or a 20% return on $1 million? A shortcoming of IRR: Because it is a return, you cannot tell how much value will actually be created without knowing the scale of the investment. IRR(Book Store)=24%, IRR(Coffee shop)=23%, Cost of capital=8% NPV(Book Store)=$960,000; NPV(Coffee shop)= $1,200,000

35. Differences in Timing Even when projects have the same scale, the IRR may lead you to rank them incorrectly due to differences in the timing of the cash flows: Example: IRR(Music Store)= 26%, NPV(Music Store)=$900,000

36. Differences in Risk To know whether the IRR of a project is attractive, we must compare it to the project’s cost of capital, which is determined by the project’s risk. An IRR that is attractive for a safe project need not be attractive for a risky project IRR(Electronics Store)= 28%, Cost of capital=11%.

37. The Incremental IRR The incremental IRR tells us the discount rate at which it becomes profitable to switch from one project to the other. Rather than compare the projects directly, we can evaluate the decision to switch from one to the other using the IRR rule.

38. Example

39. Example The incremental IRR of switching from the minor overhaul to the major overhaul.

40. Example

41. Shortcomings of incremental IRR Even if the negative cash flows precede the positive ones for the individual projects, it need not be true for the incremental cash flows. If not, the incremental IRR is difficult to interpret, and may not exist or may not be unique. The incremental IRR can indicate whether it is profitable to switch from one project to another, but it does not indicate whether either project has a positive NPV on its own. When the individual projects have different costs of capital, it is not obvious what cost of capital the incremental IRR should be compared to. In this case only the NPV rule, which allows each project to be discounted at its own cost of capital, will give a reliable answer.

42. Capital rationing Your company has a fixed of $1000 and has opportunity to invest in four projects:

43. Capital rationing Your company has a fixed of $1000 and has opportunity to invest in four projects:

44. Mutually exclusive projects with unequal lives

45. Mutually exclusive projects wit unequal lives

46. Capital Budgeting Forecasting Earnings Revenue and cost estimates Incremental Earnings Forecast Interest expenses Some issues FCF and NPV

47. Example Let’s consider a hypothetical capital budgeting decision faced by managers of the Linksys division of Cisco Systems, a maker of consumer networking hardware. Linksys is considering the development of a wireless home networking appliance, called HomeNet , that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting PCs and printers, HomeNet will control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. Linksys has already conducted an intensive, $300,000 feasibility study to assess the attractiveness of the new product.

48. Example-Revenue and cost estimates HomeNet’s target market is upscale residential “smart” homes and home offices. Based on extensive marketing surveys, the sales forecast for HomeNet is 100,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life. It will be sold through high-end electronics stores for a retail price of $375, with an expected wholesale price of $260. Developing the new hardware will be relatively inexpensive, as existing technologies can be simply repackaged in a newly designed, home-friendly box. Industrial design teams will make the box and its packaging aesthetically pleasing to the residential market. Linksys expects total engineering and design costs to amount to $5 million. Once the design is finalized, actual production will be outsourced at a cost (including packaging) of $110 per unit.

49. Example-Revenue and cost estimates In addition to the hardware requirements, Linksys must build a new software application to allow virtual control of the home from the Web. This software development project requires coordination with each of the Web appliance manufacturers and is expected to take a dedicated team of 50 software engineers a full year to complete. The cost of a software engineer (including benefits and related costs) is $200,000 per year. To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Linksys must also install new equipment that will require an upfront investment of $7.5 million. The software and hardware design will be completed, and the new equipment will be operational, at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.8 million per year on marketing and support for this product.

50. Incremental Earnings Forecast

51. Capital Expenditures and Depreciation While investments in plant, property, and equipment are a cash expense, they are not directly listed as expenses when calculating earnings. Instead, the firm deducts a fraction of the cost of these items each year as depreciation.

52. Interest Expenses When evaluating a capital budgeting decision, we generally do not include interest expenses. Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project. Here we wish to evaluate the project on its own, separate from the financing decision.

53. Taxes The correct tax rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar of pre-tax income. HomeNet will reduce Cisco’s taxable income in year 0 by $15 million. As long as Cisco earns taxable income elsewhere in year 0 against which it can offset HomeNet’s losses, Cisco will owe $15 million * 40% = $6 million less in taxes in year 0. The firm should credit this tax savings to the HomeNet project.

54. Unlevered Net Income Calculation Unlevered net income= net operating profit after tax (NOPAT).

55. Opportunity Costs Suppose HomeNet’s new lab will be housed in warehouse space that the company would have otherwise rented out for $200,000 per year during years 1–4. How does this opportunity cost affect HomeNet’s incremental earnings?

56. Project externalities Example: Suppose that approximately 25% of HomeNet’s sales come from customers who would have purchased an existing Linksys wireless router if HomeNet were not available . For the cannibalization, suppose that the existing router wholesales for $100 so the expected loss in sales is $25% * 100,000 units * $100/unit = $2.5 million Suppose the cost of the existing router is $60 per unit.

57. Incremental Earnings Forecast

58. Determining Free Cash Flow and NPV Earnings are an accounting measure of the firm’s performance. They do not represent real profits: The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. To evaluate a capital budgeting decision, we must determine its consequences for the firm’s available cash. The incremental effect of a project on the firm’s available cash is the project’s free cash flow.

59. Depreciation Depreciation is not a cash. The effects of different depreciation methods on the FCF are through the deferral of tax expenses. At terminal year, salvage value of fixed assets and its effect on taxes must be included in the calculation of cash flows.

60. Net Working Capital (NWC) Any increases in net working capital represent an investment that reduces the cash available to the firm and so reduces free cash flow . Required working capital increases when firms proceed additional projects. When projects end, working capital is recovered .

61. Net Working Capital (NWC)- Example Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS).

62. Net Working Capital (NWC)- Example

63. Free Cash Flow

64. Calculating Free Cash Flow Directly

65. Calculating the NPV To compute HomeNet’s NPV, we must discount its free cash flow at the appropriate cost of capital. The cost of capital for a project is the expected return that investors could earn on their best alternative investment with similar risk and maturity. Assume that Cisco’s managers believe that the HomeNet project will have similar risk to other projects within Cisco’s Linksys division, and that the appropriate cost of capital for these projects is 12%.

66. Calculating the NPV

67. Liquidation or Salvage Value Assets that are no longer needed often have a resale value or some salvage value if the parts are sold for scrap. Some assets may have a negative liquidation value. For example, it may cost money to remove and dispose of the used equipment. Gain on Sale = Sale Price - Book Value Book Value = Purchase Price – Accumulated Depreciation Adjust the project’s free cash flow to account for the after-tax cash flow: would result from an asset sale

68. Example Suppose that in addition to the $7.5 million in new equipment required for HomeNet , some equipment will be transferred to the lab from another Linksys facility. This equipment has a resale value of $2 million and a book value of $1 million. If the equipment is kept rather than sold, its remaining book value can be depreciated next year. When the lab is shut down in year 5, the equipment will have a salvage value of $800,000. What adjustments must we make to HomeNet’s free cash flow in this case?

69. Example

70. Calculating Free Cash Flow Directly (1) Free Cash Flow The term t c × Depreciation is called the depreciation tax shield.

71. Calculating Free Cash Flow Directly (2) Cash flow collected by year Outlay = FCInv + NWCInv  Initial Outlay in year 0   CF=(S-C-D) (1-T) + D  Annual after-tax operating cash flow   TNOCF= Sal T + NWCInv - T( Sal T -B T ) (terminal year incremental after-tax non operating CF):

72. Example: Investment outlays (year 0) : $200,000 for fixed capital items ($25,000 for nondepreciable land and $175,000 for equipment that will be depreciated straight-line to zero over five years) Working capital: $50,000 of current assets; $20,000 in current liabilities (year 0- year 4) Year 1-5: sales will be $220,000 and cash operating expenses will be $90,000. Income taxes: 40 percent Year 5: sell off the fixed capital assets (including the land) for $50,000. NWC is recovered. Cost of capital: 10%

73. Choosing Among Alternatives Compare mutually exclusive alternatives, each of which has consequences for the firm’s cash flows. Compute the free cash flow associated with each alternative and then choosing the alternative with the highest NPV. When comparing alternatives, we need to compare only those cash flows that differ between them. We can ignore any cash flows that are the same under either scenario.

74. Example Suppose Cisco is considering an alternative manufacturing plan for the HomeNet product. The current plan is to fully outsource production at a cost of $110 per unit. Alternatively, Cisco could assemble the product in-house at a cost of $95 per unit. However, this will require $5 million in upfront operating expenses to reorganize the assembly facility, and starting in year 1 Cisco will need to maintain inventory equal to one month’s production. (Receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS)). Cost of capital:12%

75. Example

76. Choosing Among Alternatives (cont'd) Evaluating Manufacturing Alternatives Outsource Cost per unit = $110 Investment in A/P = 15% of COGS COGS = 100,000 units × $110 = $11 million Investment in A/P = 15% × $11 million = $1.65 million Δ NWC = –$1.65 million in Year 1 and will increase by $1.65 million in Year 5 NWC falls since this A/P is financed by suppliers

77. Choosing Among Alternatives (cont'd) Evaluating Manufacturing Alternatives In-House Cost per unit = $95 Up-front cost of $5,000,000 Investment in A/P = 15% of COGS COGS = 100,000 units × $95 = $9.5 million Investment in A/P = 15% × $9.5 million = $1.425 million Investment in Inventory = $9.5 million / 12 = $0.792 million Δ NWC in Year 1 = $0.792 million – $1.425 million = –$0.633 million NWC will fall by $0.633 million in Year 1 and increase by $0.633 million in Year 5

78. Choosing Among Alternatives (cont'd) Evaluating Manufacturing Alternatives Table 8.6 Spreadsheet NPV Cost of Outsourced Versus In-House Assembly of HomeNet

79. Choosing Among Alternatives (cont'd) Comparing Free Cash Flows Cisco’s Alternatives Outsourcing is the less expensive alternative.

80. Textbook Example 8.5

81. Cash flows for a replacement project We are considering the replacement of old equipment project with new equipment that has more capacity and is less costly to operate. The characteristics the old and the new equipment are given below:

82. Cash flows for a replacement project: One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over 10 years, after which it has no salvage value. You expect that the new machine will produce EBITDA (earning before interest, taxes, depreciation, and amortization) of $40,000 per year for the next 10 years. The current machine is expected to produce EBITDA of $20,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no salvage value, so depreciation expense for the current machine is $10,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000. Your company’s tax rate is 45%, and the opportunity cost of capital for this type of equipment is 10%. Is it profitable to replace the year-old machine?

83. Cash flows for a replacement project

84. Cash flows for a replacement project If the new equipment replaces the old equipment, an additional investment of $80,000 on net working capital will be required. The tax rate is 30 percent, and the required rate of return is 8 percent. Is it profitable to replace the year-old machine?

85. Cash flows for a replacement project Outlay = FCInv + NWCInv - Sal + T(Sal -B )   CF=(S-C-D) (1-T) + D   TNOCF= Sal T + NWCInv - T( Sal T -B T ) (terminal year incremental after-tax non operating CF):

86. Problem 1 FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an additional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year life. The equipment will generate additional annual revenues of $265,000, and it will have annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory investment of $73,000 is required during the life of the investment. FITCO is in the 40 percent tax bracket and its cost of capital is 10 percent. What is the project NPV?

87. Weighted Average Cost of Capital Cost of equity- rE Cost of debt – rD Unlevered cost of capital- rU Weighted Average cost of capital- rWACC Based on the firm’s cost of equity and debt Based on comparable firms

88. Reading Berk , Ch12, Estimating cost of capital 12.1. Equity Cost of Capital 12.3. Beta estimation 12.4. Debt cost of capital 12.5. A project’s cost of capital 12.6 Financing and Weighted Average cost of capital

89. Weighted Average Cost of Capital If a firm is financed with both equity and debt, then the risk of its underlying assets will match the risk of a portfolio of its equity and debt. The appropriate cost of capital for the firm’s assets is the weighted average of the firm’s equity and debt cost of capital  Unlevered cost of capital, or pretax WACC.

90. Interest Tax Shield

91. Interest Tax Shield Additional income = 150 = Interest payment * Corporate Tax Rate  Interest Tax Shield

92. Interest Tax Shield Tax: 35%, debt: $100.000, interest rate=10% Effective cost of the debt= $6,500/$100,000 = 6.50% = Interest Rate * (1- Tax)

93. Weighted Average Cost of Capital With tax:

94. Cost of equity: historical stock returns, CAPM, DDM, Cost of debt plus risk premium,… Cost debt: some firms (large proportion) do not estimate cost of equity and use cost of debt to discount cash flows Weighted Average Cost of Capital

95. The Equity Cost of Capital The Capital Asset Pricing Model (CAPM) is a practical way to estimate. The cost of capital of any investment opportunity equals the expected return of available investments with the same beta. The estimate is provided by the Security Market Line equation: Risk Premium for Security i

96. Example Suppose you estimate that eBay’s stock has a volatility of 30% and a beta of 1.45. A similar process for UPS yields a volatility of 35% and a beta of 0.79. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 3% and you estimate the market’s expected return to be 8%, calculate the equity cost of capital for eBay and UPS. Which company has a higher cost of equity capital?

97. Beta estimation

98. Debt Cost of Capital Debt Betas Alternatively, we can estimate the debt cost of capital using the CAPM. Debt betas are difficult to estimate because corporate bonds are traded infrequently. Chapter 21 shows a method for estimating debt betas. One approximation is to use estimates of betas of bond indices by rating category.

99. Table 12.3 Average Debt Betas by Rating and Maturity

100. Problem Consider a firm with a debt-to-value ratio of 25%, a debt cost of capital of 6.67%, an equity cost of capital of 12%, and a tax rate of 40%. Suppose the firm increases its debt-to-value ratio to 50%. What is the WACC?

101. Weighted Average Cost of Capital (WACC). Adjusted Present Value (APV) Flow-to- E quity The examples in this chapter are based on the following assumptions: The project has average risk. The firm’s D/E ratio remains constant. Corporate taxes are the only imperfections. Three common methods of capital budgeting

102. Estimate project’s free cash flows . Calculate WACC. Accept/Reject the project based on NPV. Is sometimes called FCF (Free-cash-flow) method. I WACC Method

103. Example Avco engineers expect the technology used in these products to become obsolete after four years. During the next four years, however, the marketing group expects annual sales of $60 million per year for this product line. Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively, per year. Developing the product will require upfront R&D and marketing expenses of $6.67 million, together with a $24 million investment in equipment. The equipment will be obsolete in four years and will be depreciated via the straight-line method over that period. Avco bills the majority of its customers in advance, and it expects no net working capital requirements for the project. Avco pays a corporate tax rate of 40%.

104. Example

105. Example

106. WACC Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the RFX project. Thus, Avco’s WACC is Note that net debt = D=320-20=$300 million.

107. Using the WACC to Value a Project (cont'd) The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows. The NPV of the project is $33.25 million $61.25 million – $28 million = $33.25 million

108. Summary of the WACC Method Determine the free cash flow of the investment. Compute the weighted average cost of capital. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

109. THE END OF CHAPTER 6