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Corporate Finance 1

Week 5: Capital Budgeting


Incremental cash flows Textbook reading (Ross, Westerfield, and Jaffe: Chapter 7, Making Capital Investment Decisions) Last week you studied the criteria used for analysing whether a project should be undertaken. The most widely used technique, NPV, requires finding the present value of cash flows expected from the project. More importantly, it was noted that these cash flows be incremental. These are the cash flows that are a direct consequence of undertaking the project. With regard to capital budgeting, these are the only relevant cash flows that need to be considered in decision making. This topic serves to examine what is included in these incremental cash flows and what is excluded. There are certain costs that organisations incur or are already committed to that are not applicable to the decision that the organisation makes about a project. Such costs are known as sunk costs and are not included in the cash flow projections. An example of a sunk cost would be a feasibility study that a firm has already conducted in order to assess the viability of a project. Whether the firm decides to pursue the project or not, the cost of the study has already been incurred and should not be considered as a part of the projects cash flows. There are certain costs that must be considered that are not always so obvious. Economic theory stresses the importance of considering the costs of foregoing certain choices. Such costs are known as opportunity costs, and they represent what has been given up as a result of picking an alternative. Suppose that a firm is planning on expanding its production, which will require utilising excess building space. This space could also be leased to another firm for 20,000/year. If the firm decides to utilise the space by expanding production, it would be foregoing the 20,000 in rent that could be received. This amount represents an opportunity cost and should be considered when computing the incremental cash flows. Firms may also consider how a project will affect other parts of the organisation. Undertaking a new capital project may benefit or hamper the profitability of other projects within the firm. If the cash flows from an existing project are expected to increase or decrease because of the new project, such changes must be considered in the cash flows of the new project. Another important aspect of the incremental cash flows to be considered in capital budgeting is that all cash flows must be computed on an after-tax basis. This is due to the fact that the firm can only consider the cash flows that are actually available for use and taxes must be paid on earnings, reducing the cash flows. This also brings to light another consideration that must be accounted for, depreciation. Depreciation is a non-cash expense that reduces the amount of operating income during the useful life of the projects asset or assets. However, when computing the

cash flows of a project, depreciation must be added back in, as accounting depreciation is not a tax allowable expense. It is important to draw a distinction between an expansion project and a replacement project. When discussing a totally new acquisition or launching a product line, these are examples of expansion projects. Such projects aim at increasing the revenues of a firm by increasing operating capacity or creating new products. A replacement project is typically encountered whenever the firm is faced with the decision to replace old equipment with new or upgrade existing machines. As Example 7.11 in the chapter illustrates, the process for evaluating a replacement project is slightly different than for an expansion project. The annual cost of keeping the old equipment is compared to the annual cost of the new equipment. If the new equipment has a lower annual cost than the old equipment, the project can be accepted. Replacement projects concentrate on improving the efficiencies within the firm. The cash flows that are examined in these notes relate to expansion projects. In identifying and computing the incremental cash flows of a project, we can group them into three general categories: cash flows occurring at the beginning of the project life (period0), cash flows occurring through the life of the project (period1 to periodn) and cash flows occurring at the termination of the project (periodn). Cash flows that occur at the beginning of a project are generally comprised of the initial investment outlays required for the new project such as the costs for new equipment, shipping and installation charges. If the project is a replacement decision, then the firm must also consider the cash flows associated with disposing of old equipment and the tax consequences of any disposal as well. As the project very often leads to an increase in activity, it is also common to see an increase in net working capital when the project starts. Remember that net working capital includes elements such as inventories (also known as stocks), receivables (also known as debtors) and payables (also known as creditors). A typical example is the launch of a new product. The company will have to build up stocks before generating the first sales, and will have to wait for customers to pay their bills. This will lead to an increase in net working capital. A summary table for the calculation of a projects initial investment is provided: Initial Investment Calculation Purchase price of new assets + Expenses necessary for placing the asset into operation + Opportunity costs + Initial net working operating capital (NWOC) needed - Funds available from sales of old assets +/- Tax effects from sale of old assets Initial investment At every stage of the project it may be necessary for the organisation to alter its working capital to help fund activities. Cash may be needed to ensure that expenses can be paid quickly; inventory may need to be increased to ensure that there are no shortages, or receivables may increase in order to support sales. As the project moves forward and nears completion, previous changes to working capital are likely

to be reversed as customers pay off their accounts, less cash is needed, and inventory levels are reduced. Cash flows that occur within the life of the project are usually generated from the normal activities of the project, such as revenues net of expenses associated with normal operating practices. In fact, the cash flows computed during this frame are often denoted as operating cash flows (OCF). Such cash flows represent the changes in the day-to-day cash flows generated by the project. OCF is computed as: Operating Cash Flow Calculation Operating revenues - Operating expenses - Depreciation Earnings before taxes and interest (EBIT) or Operating Profit - Taxes on EBIT Net Operating Profit After Tax (NOPAT) + Depreciation +/- Changes in net working capital (NWC) Operating cash flows It is important to note that the income metric used in the calculation of incremental cash flows, net operating profit after tax, usually differs from net income, the bottom line of the income statement. Net income accounts for interest expense, but interest expense is not included in incremental cash flows. Remember that incremental cash flows should capture all operating and investing activities associated to the project. Interest expense is the consequence of borrowing money and as such, it is part of financing activities. It therefore wont be reflected in the incremental cash flows, but in the cost of capital, which is where financing activities are taken into account. In Week 8, we will come back to this when we study the cost of capital. Also note that to find the total cash flows, it is necessary to add back depreciation, as this is a noncash expense. Terminal cash flows are those that occur at the end of the project and often involve the disposal of the project. With this regard, it is necessary to consider any salvage values of assets that can be sold as well as the tax effects. A summary table for how terminal value is calculated is provided: Terminal Value Calculation Salvage value - Expenses necessary for disposal of assets Salvage value before taxes +/- Tax effects from disposal Net salvage value + Recovery of net working capital (NWC) Terminal cash flows More details as to how to calculate these elements is given in your textbook. The case study in your reading, the Baldwin Company, illustrates how total cash flows are computed for each period within a project. This case covers all of the important

concepts related to incremental cash flows, from how to account for taxes to changes in working capital. With the incremental cash flows of a project determined, a firm can then apply the investment criteria that were examined last week, such as NPV and IRR, to evaluate the value that a project will contribute to the organisation. Another consideration is the amount of cash that the company is able to generate after it has paid out money required to maintain or increase its asset base. Free cash flow is a measure of financial performance that is calculated by taking operating cash flow minus capital expenditures and is important to consider because it is this amount that is available for the company to use to pursue opportunities that will increase the shareholder value. This measure is believed to provide greater insight into the ability of the firm to generate cash and, ultimately, profits. Impact of inflation on the capital budgeting process and criteria Textbook reading (Ross, Westerfield, and Jaffe: Chapter 7, Making Capital Investment Decisions) As a student of finance, you are most likely aware of inflation and its impact on future earnings. By definition, inflation is an increase in the overall price of goods and services over a period of time. This means that 10 today will purchase more than 10 will in one year from now. We can also see this effect when analysing interest rates. Consider the example of a financial institution that pays 5% on a savings account. If you deposited 100 in this account, in one year you would have 105 (100 + 5 in interest). However, the rate of inflation over this same period of time was 3%. The interest rate paid by the financial institution is known as the nominal rate of interest, and the rate that was actually earned (after accounting for inflation) is known as the real rate of interest. To find the effect that inflation had on the earnings (the real interest rate), we can use what is called the Fisher equation:

Which can be rewritten as:

For our example, the computation would look like this:

Because of the effect that inflation has on earnings, it is necessary to discuss its implications in capital budgeting. In the Baldwin Company example from your text, the total cash flows computed for each period were nominal cash flows. If the company is using nominal cash flows, they should be discounted using a nominal discount rate. On the other hand, if the company is using real cash flows, they should be discounted using a real discount rate. It is important that the organisation

remains consistent to have reliable and comparable results between projects. When inflation impacts all cash flows the same way and at the same time, the nominal and real approaches are equivalent, but it is usually simpler to use nominal cash flows and the nominal discount rate as this reduces the calculations needed. However, an organisation may want to know the real cash flows to be expected. Your reading for this topic provides excellent worked examples of nominal and real cash flows. Project analysis Textbook reading (Ross, Westerfield, and Jaffe: Chapter 8, Risk Analysis, Real Options, and Capital Budgeting) In our ex amination o f c apital b udgeting t o t his point w e hav e focused on the techniques and methods that are used to evaluate an expected stream of cash flows. This represents a v ital and si gnificant p ortion o f t he overall ca pital b udgeting process; however, it does not represent the entire realm of capital budgeting. As you have seen, the most widely used m ethods, such as NPV and IRR, require that the organisation computes the incremental cash flows that are expected from a project. These ca sh flows are est imations, d eveloped by oper ational, f inancial, an d marketing managers, and ar e o ften pr ojected m any periods into the f uture. Is it logical to assume that these computations will be completely accurate? The common sense answer to that question is a resounding NO! We know that organisations face numerous factors and variables that will affect the accuracy and consistency of cash flows that w ere co mputed. It i s then nec essary t o pr operly acco unt for p ossible variations and understand what effect this may have on the value of a project. The nex t t wo t opics examine m ethods and appr oaches for anal ysing t he r isk and variability that a project presents. These methods attempt to capture and account for the pr obability t hat ev ents may not ha ppen as the or ganisation or iginally pl anned. Different a pproaches are use d to account for di fferent el ements, such as changing sales projections or t he opt ion to m ake de cisions as t he pr oject un folds. K eep i n mind as you ex amine t hese t echniques that an or ganisation should ut ilise a combination of them rather than just a single approach. Basic risk analysis, including scenario analysis, sensitivity analysis and Monte Carlo simulations Textbook reading (Ross, Westerfield, and Jaffe: Chapter 8, Risk Analysis, Real Options, and Capital Budgeting) The first group of techniques that you will examine involve assessing the amount of risk involved with a project. If you will recall the Baldwin Company example from the previous chapter, a portion of the cash flows for the project were based on how many units were to be sold and the expected price per unit. Organisations must estimate the revenues that are expected from a project based on projections of market share, demand, price, and expenses. Sensitivity analysis shows us how changes to one of these variables will affect the NPV or the IRR. This type of analysis answers the what if questions, such as what if sales drop by 30%? or what if our expenses are 20% higher? or what if the cost of capital increases by two

points?. When conducting this type of analysis, each variable but one is held constant to test its effect on the end result. By examining all of the variables in this manner, sensitivity analysis helps managers to determine which of the variables are more significant contributors of change to the NPV or the IRR. The variable or variables that cause the NPV or the IRR to change in a greater degree must be carefully estimated and monitored as it is these variables that will have a greater effect on the value of the project. Scenario analysis examines several possible situations, usually a best case scenario, a most likely case scenario, and a worst case scenario. For each situation, all of the variables are changed to reflect the possible outcome. For example, in a worst-case scenario, the organisation may use their worst possible sales figures, prices, and expenses. Here, the focus is on a deviation of a combination of related variables. This reflects a distinction from sensitivity analysis, which concentrates on the change in a single variable at a specific point of time. This is a significant advantage of scenario analysis, as the variables being examined are generally dependent to some degree. You are likely familiar with break-even analysis from previous studies. This technique analyses the fixed and variable costs associated with a product and, based on a given price per unit, determines how many units must be sold in order for the organisation to break-even (cover all costs). Break-even analysis can also be applied to capital budgeting and is viewed as a complement to sensitivity analysis. When used in this application, it is necessary to calculate the break-even point in comparison to the NPV of the project. This is because the normal break-even method analyses the number of units it would take to cover fixed and variable costs. In relation to a project, fixed costs usually represent the investment required. However, when analysing a capital project we need to know how many units are needed to cover opportunity costs as well. This is because the companys money could have been used for a different investment. The opportunity costs (usually represented by the required rate of return) are included in the analysis to arrive at a break-even point for the project. Using sensitivity analysis (changing one variable), we can then see to what degree the break-even point changes for the project. An organisation may find that its break-even point under certain scenarios may not be attained realistically, demonstrating that the project may have too much risk or its profit potential is limited. Used along with sensitivity analysis, break-even analysis is a useful and practical approach for managers with regard to analysing the risk associated with a project. Sensitivity analysis and scenario analysis provide insight regarding the risk associated with a project, yet these techniques are limited. As you have seen, sensitivity analysis only allows for one variable to be changed at a given time. We know that variables are often dependent upon one another (i.e., a drop is sales may require the company to lower its price), so sensitivity analysis does not provide a complete picture. Scenario analysis helps to overcome this somewhat by examining different combinations of the variables, realising that each is somewhat dependent on the others. However, scenario analysis generally only examines a few possible combinations (e.g., best case, most likely case, and worst case). In reality, there are seemingly endless possibilities when you consider the probabilities involved. Monte

Carlo simulations help to overcome the drawbacks associated with sensitivity and scenario analysis. Monte Carlo simulations allow organisations to model all possible combinations of scenarios for the uncertain variables. This process is completed by assigning a range of probabilities to each variable. As you may begin to realise, completing such simulations manually would prove to be rather difficult, tedious, and time consuming. With the assistance of computer software, such combinations can be processed rather quickly and the simulation produces the probability distribution of project cash flows (and NPVs) as well as sensitivity figures for each of the models assumptions. The chapter assigned for this reading provides illustrations for each type of analysis that we have discussed here. As you progress through this section you will see that Monte Carlo simulations are a far superior technique for analysing the risk involved with a project and can produce a more reliable NPV. While you will examine the actual process of how such a simulation is carried out, you should not become overwhelmed with it. Simulation software bears the responsibility of carrying out this task. However, it is important that you understand the concept behind the technique. Real Options Textbook reading (Ross, Westerfield, and Jaffe: Chapter 8, Risk Analysis, Real Options, and Capital Budgeting) Organisations and the managers within them have choices. Once a project is started, it does not mean that the organisation will maintain the same methods or strategies throughout the entire life of the project. Rather, there may be opportunity for expansion if the project is more successful than originally planned, or the firm can decide to abandon a project if it is not successful. In fact, managers may even have the opportunity to delay a project before it even starts, resulting in choices and flexibility before a project ever begins. Moreover, the very nature of a project may allow for additional alternatives. Follow-on investments are similar to expansion, but differ in that they are usually a different project altogether, yet would have most likely not been possible if not for the first project (movie sequels are a good example of this). Some projects may have flexibility in that they are able to produce multiple outputs or be completed using a combination of methods. The choices that a firm has with regard to a business investment or project are known as real options. They are known as options, not simply because they represent choices, but also because they represent value to the organisation. You may be asking yourself how choices represent value. In terms of valuation, real options do have value because in a world ripe with uncertainty, they allow managers to react to changing scenarios and situations, thus allowing them to alter the capital budgeting decision process as needed. However, one of the most popular methods, NPV, ignores that value that such options represent. By placing a value on flexibility and choice, real options can be used to augment the NPV approach. Using real options as part of the capital budgeting process often utilises a decision tree technique. A decision tree allows the firm to concentrate on the most important decisions while identifying the decisions that need to be made at certain points in the

project. Often one decision will produce a new set of choices, creating another decision point. This process continues until there are no more choices. A decision tree is constructed by using reason to move forward through possible decisions to construct the tree while the certainties and uncertainties associated with each decision point are tracked. The choices are then evaluated by working backwards through the tree, with the tree branch with the highest expected value being selected. The examples provided in the textbook reading will help to illustrate how real options can create additional value to a project, even making a project with a negative NPV worth monitoring rather than rejecting immediately. You will also see how decision trees are constructed and used with this approach. The journal article reading for this week further explores how real options can be used in capital budgeting decisions.

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