FIN 468 Intermediate Corporate Finance Topic 3 Capital Budgeting Larry Schrenk Instructor 1 of 22 Topics Review of Decision Rules Incremental Cash Flow Analysis Model to Value the Net Cash Flows Investments of Unequal Lives Decision Rules Decision Rules Payback Period Discounted Payback Period Net Present Value NPV Internal Rate of Return IRR Modified Internal Rate of Return MIRR Criteria for Decision Rules Recognize the time value of money Incorporate all relevant free cash flows Minimize arbitrary assumptions Minimize need for uncertain data Minimize excessive calculation complexity Minimize problems Data For simplicity we shall use the following cash flows for many of our examples r 10 0 1 000 1 300 2 200 3 400 4 700 Payback Period EXAMPLE 0 1 000 2 200 3 400 4 700 3 Year Payback Period Calculation 1 300 300 200 400 900 1 000 Result 900 00 1 000 00 Bad Project Discounted Payback Period EXAMPLE r 10 0 1 000 1 300 2 200 3 400 4 700 3 Year Discounted Payback Period Calculation 300 00 200 00 400 00 738 54 1 000 00 2 3 1 1 1 1 1 1 Result 738 54 1 000 00 Bad Project Net Present Value NPV EXAMPLE r 10 0 1 000 1 300 2 200 3 400 4 700 NPV Calculation 300 00 200 00 400 00 700 00 1 000 216 65 0 2 3 4 1 1 1 1 1 1 1 1 Result 216 65 0 Good Project Internal Rate of Return IRR EXAMPLE r 10 0 1 000 1 300 2 200 3 400 4 700 IRR Calculation 300 00 200 00 400 00 700 00 0 2 3 4 1 IRR 1 IRR 1 IRR 1 IRR 1 000 iff IRR 18 1 18 1 10 Result 18 1 10 Good Project Modified Internal Rate of Return EXAMPLE r 10 0 1 000 1 300 2 200 3 400 4 700 Find the MIRR that makes the present value of all cash outflows equal to the present value of the terminal value 1 781 30 MIRR s t 1 000 1 MIRR 4 MIRR 15 53 Result 15 53 10 Good Project Summary of the Five Rules Ineffective Rules Payback Period Payback period cash flow investment Discounted Payback Period Discounted payback period cash flow investment Effective Rules NPV NPV 0 IRR IRR r MIRR MIRR r Some Additional Issues Some Additional Issues Comparing NPV IRR PI and MIRR Using Decision Rules to Compare or Select among Projects Sign Changes in the Cash Flows and Multiple IRR s Capital Budgeting 15 of 22 Topics Two General Principles Factors in Cash Flow Analysis Fixed versus Variable Costs Depreciation Working Capital Taxes Interest Payments and Financing Costs Sunk Costs Opportunity Costs Externalities Two General Principles Principle One Use Increments The Incremental Approach to Cash Flow Analysis Principle Two Use Real Cash Flows Real versus Accounting Cash Flows The Incremental Approach The Incremental Approach to Cash Flow Analysis Incremental How real cash flows change Alternate Averages Comparison Example New Project Costs Cost Before Furniture 10 000 Software 9 000 Insurance 4 000 After 12 000 9 000 6 000 Average Increment Comparison Example Average Approach Cost Before Furniture 10 000 Software 9 000 Insurance 4 000 After 12 000 9 000 6 000 Average 4 000 3 000 2 000 Increment Comparison Example Incremental Approach change in costs i e the increment associated with the new project Cost Before Furniture 10 000 Software 9 000 Insurance 4 000 After 12 000 9 000 6 000 Average 4 000 3 000 2 000 Increment 2 000 0 2 000 Comparison Example Conclusion Use the increment Cost Before Furniture 10 000 Software 9 000 Insurance 4 000 After 12 000 9 000 6 000 Average 4 000 3 000 2 000 Increment 2 000 0 2 000 Real versus Accounting Values Real Actual transfers of value at this time Market values Money assets etc Accrual Accounting May not be market values Goodwill depreciation May not be current accrued payable NOTE Possible ambiguity Real versus Accounting Real versus Nominal Real versus Accounting Example Payment of 6 000 for insurance over the next three years Accounting Real Real versus Accounting Example Accrual Accounting Cash Flow Matching Profit Accounting 2 000 2 000 2 000 Real Real versus Accounting Example Real Cash Flow Accounting Real 2 000 6 000 2 000 0 2 000 0 Real versus Accounting Cash Flows A Complication Non real cash flow has an effect on a real cash flow Incorporate the effect but not non real cash flow itself Depreciation Factors in Cash Flow Analysis Factors in Cash Flow Analysis Depreciation Working Capital Taxes Interest Payments and Financing Costs Sunk Costs Opportunity Costs Externalities Depreciation Depreciation Depreciation not real cash flow Effects on real cash flow i e taxes If a firm had no taxable income then we could ignore depreciation Incorporate the tax effect of depreciation not the depreciation itself Classes of Expenditures Costs expensed In theory the value is exhausted during that one period E g Stationary production materials etc Deductible Investments Over time In theory the value is exhausted over multiple periods E g Factory equipment computers etc Non Deductible Investments Never In theory the value is never exhausted Depreciation Different methods schedules and over different lengths of time MARCS Example Schedule 1 2 3 4 20 32 19 2 11 52 11 52 5 76 Capital investment 1 000 000 Yearly depreciation is 1 2 3 4 5 5 6 6 200 000 320 000 192 000 115 200 115 200 57 600 For More Depreciation Details If you actually want to know more To dip in your toe http www irs gov businesses small article 0 id 137026 00 html Not for the faint of heart Publication 946 2005 How To Depreciate Property http www irs gov publications p946 index html Depreciation Calculation 1 2 3 4 Begin with gross income EBDIT Subtract the depreciation to get taxable income EBIT Subtract the taxes based on this taxable income to get net income Add depreciation back to net income to get operating cash flow Depreciation Example Gross Income EBDIT Less Depreciation Taxable Income EBIT Less Taxes tC 35 Net Income Plus Depreciation Real Cash Flow 200 000 50 000 150 000 52 500 97 500 50 000 147 500 Working Capital Working Capital Metaphorically the grease that keeps the machine of business going Production takes place over time Materials paid for long before product sold Money must be available for suppliers employees etc This investment is working capital Working Capital All working capital eventually returned Working capital as a loan to the project But cost to tying up value in working capital Calculations Increase in working capital negative CF Decrease in working capital positive CF Working Capital Example Initial working capital required 10 000 Working capital must be10 of sales Period 0 1 2 3 4 Sales 0 130 000 150 000 90 000 50 000 WC 10 000 13 000 15 000 9 000 5 000