Expenditure Decisions

DCF Methodologies

The ability to restructure expenditure proposals

means that expenditure analysis can be iterative
and circular as illustrated below:

Proceed with
Project Project Forecast Outcome
Implementation
Proposal Analysis Positive (+ NPV)
Planning

Forecast
Restructure Outcome Not
Proposal Viable (- NPV)

3-1
 Expenditure Decisions
DCF Methodologies

All discounted cash flow approaches

require:
– Estimate of the initial cost of the Expenditure
– Estimate of the net incremental after-tax cash
flow benefits the investment is likely to produce
(we need to know when these cash flows will
occur and how large they will be)
– Estimate of the required rate of return on the
project (relevant discount rate k)
Evaluating Investment Alternatives
The Cash Flow Pattern for a Traditional Capital Expenditure

0 1 2 3 … n

CF1 CF2 CF3 … CFt

CF0

Where CFt = estimated future after-tax incremental cash flow at

time t
CF0 = the initial after-tax incremental cash outlay
 Evaluation of Investment Alternatives
DCF Methodologies

• Net Present Value (NPV)

• Internal Rate of Return (IRR)
• Payback Period and Discounted Payback
Period
• Profitability Index (PI)
 Evaluating Investment Alternatives
Net Present Value (NPV) Analysis

NPV = the sum of the present value of all benefits minus the
present value of costs

n
Cash Flow Benefitsi
NPV    Initial Co st
i 1 ( 1  k)i

If benefits > cost, NPV will be positive and the project

is acceptable.

If benefits < cost, NPV will be negative and the

project is unacceptable because it destroys firm
value.
 NPV Example
The Formula-based Approach

Problem:
• Initial outlay = $12,000
CF1 CF2 CF3
• After-tax cash flow benefits: NPV     CF0
– Year 1 = $5,000 (1  k ) (1  k ) (1  k )
1 2 3

– Year 2 = $5,000 $5,000 $5,000 $8,000

– Year 3 = $8,000  1
 2
 3
 $12,000
(1.15) (1.15) (1.15)
• Discount rate (k) = 15%
 $4,348  $3,781  $6,260  $12,000
 $1,389
 NPV Example
The Spreadsheet Approach

Problem:
• Initial outlay = $12,000
• After-tax cash flow benefits
(ATCF):
– Year 1 = $5,000
Initial cost = $12,000
– Year 2 = $5,000 Cost of Capital = 15.0%

– Year 3 = $8,000
After-tax Present
• Discount rate (k) = 15% Year Cashflow incremental CF PV Factor Value
0 Initial cost -$12,000 1 -$12,000
1 ATCF operating benefit 5,000 0.869565 $4,348
2 ATCF operating benefit 5,000 0.756144 $3,781
3 ATCF operating benefit 8,000 0.657516 $5,260
NPV = $1,389
 NPV Example
A Spreadsheet Modeling Approach

Here is a spreadsheet
The NPV model
result is positive used
and the to calculate
project a $100,000
is acceptable projectthe
because that
has a 6 looks
project year life,
likeoffers equal annual
it will increase after-tax
the value cash
of the firmflow
withbenefits
these over that
life of $60,000 per annum when the relevant cost of capital is 12%.
assumptions.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 12%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.892857 $53,571
2 ATCF operating benefit 60,000 0.797194 $47,832
3 ATCF operating benefit 60,000 0.71178 $42,707
4 ATCF operating benefit 60,000 0.635518 $38,131
5 ATCF operating benefit 60,000 0.567427 $34,046
6 ATCF operating benefit 60,000 0.506631 $30,398
NPV = $146,684
 NPV Example
Stress Testing the Project

Noticeletthat
Now, us at a 0%– discount
stress test the model.
rate, all We
of the
canpresent
start byvalue
setting
the discount
factors become
rate1.toAnd
0%.we (ie.work
No time
with value
absolute
to money)
dollar values.
NPV is forecast to be it’s greatest at a 0% discount rate.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 0%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 1 $60,000
2 ATCF operating benefit 60,000 1 $60,000
3 ATCF operating benefit 60,000 1 $60,000
4 ATCF operating benefit 60,000 1 $60,000
5 ATCF operating benefit 60,000 1 $60,000
6 ATCF operating benefit 60,000 1 $60,000
NPV = $260,000
 NPV Example
Stress Testing the Project

Increasing the discount rate to 5%, we discount the more

distant cash flows more heavily and the NPV of the project
falls from $260,000 to $204,542.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 5%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.952381 $57,143
2 ATCF operating benefit 60,000 0.907029 $54,422
3 ATCF operating benefit 60,000 0.863838 $51,830
4 ATCF operating benefit 60,000 0.822702 $49,362
5 ATCF operating benefit 60,000 0.783526 $47,012
6 ATCF operating benefit 60,000 0.746215 $44,773
NPV = $204,542
 NPV Example
Stress Testing the Project

Increasing the discount rate to 10%, the NPV of the project

falls from $204,542 (at 5%) to $161,316.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 10%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.909091 $54,545
2 ATCF operating benefit 60,000 0.826446 $49,587
3 ATCF operating benefit 60,000 0.751315 $45,079
4 ATCF operating benefit 60,000 0.683013 $40,981
5 ATCF operating benefit 60,000 0.620921 $37,255
6 ATCF operating benefit 60,000 0.564474 $33,868
NPV = $161,316
 NPV Example
Stress Testing the Project

Increasing the discount rate to 20%, the NPV of the project

falls to $99,531.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 20%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.833333 $50,000
2 ATCF operating benefit 60,000 0.694444 $41,667
3 ATCF operating benefit 60,000 0.578704 $34,722
4 ATCF operating benefit 60,000 0.482253 $28,935
5 ATCF operating benefit 60,000 0.401878 $24,113
6 ATCF operating benefit 60,000 0.334898 $20,094
NPV = $99,531
 NPV Example
Stress Testing the Project

ItIncreasing
is hard to imagine
the discount
a project
rate to
having
50%, risk
the that
NPVrequires
of the project
a return
offalls
moreto $9,465.
than 50%. Even at a discount rate of 50%, the
project has a positive NPV!

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 50%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.666667 $40,000
2 ATCF operating benefit 60,000 0.444444 $26,667
3 ATCF operating benefit 60,000 0.296296 $17,778
4 ATCF operating benefit 60,000 0.197531 $11,852
5 ATCF operating benefit 60,000 0.131687 $7,901
6 ATCF operating benefit 60,000 0.087791 $5,267
NPV = $9,465
 NPV Example
Stress Testing the Project

Somewhere
Increasing thebetween
discount50%rateand 60%,the
to 60%, theNPV
NPVofturned to $0.
the project
Remember,
falls the IRR
to -$5,960. of the
At that projectrate,
discount is that
thediscount rate that
project would
causes the
decrease theNPV to of
value bethe
equalfirmtoif$0.00
accepted.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 60%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.625 $37,500
2 ATCF operating benefit 60,000 0.390625 $23,438
3 ATCF operating benefit 60,000 0.244141 $14,648
4 ATCF operating benefit 60,000 0.152588 $9,155
5 ATCF operating benefit 60,000 0.095367 $5,722
6 ATCF operating benefit 60,000 0.059605 $3,576
NPV = -$5,960
 NPV Example
Stress Testing the Project

Now we can
A discount graph
rate the resultscauses
of 55.8055% of the stress
the NPVtest. NPV
to be is on
equal to
$0. vertical
the This isaxis
the project’s
because IRR.
it is the dependent variable and
discount rate is on the horizontal.

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 6
Cost of Capital = 55.8055%

Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit 60,000 0.641826 $38,510
2 ATCF operating benefit 60,000 0.41194 $24,716
3 ATCF operating benefit 60,000 0.264394 $15,864
4 ATCF operating benefit 60,000 0.169695 $10,182
5 ATCF operating benefit 60,000 0.108915 $6,535
6 ATCF operating benefit 60,000 0.069904 $4,194
NPV = $0
 Project NPV Profile

NPV
$
$260,000

0 0% 5% 10% 20% 40% 50% 60%

IRR = 55.8%

Discount Rate (%)

 Project NPV Profile

NPV
$
$260,000
IF the appropriate
discount rate (k) is
12%, then the NPV is
$146,684 forecast to be positive.

0 0% 5% 10% 20% 40% 50% 60%

IRR = 55.8%

Discount Rate (%)

 Project NPV Profile

NPV
$ Even if your estimate of the
$260,000 project’s required return (RADR)
is wrong, the project’s NPV
remains positive over a wide
range of values for k (from 0% to
$146,684 55%)

0 0% 5% 10% 20% 40% 50% 60%

IRR = 55.8%

Discount Rate (%)

 NPV Profiles

• The slope of the NPV profile depends on the

timing and magnitude of cash flows.
• Projects with cash flows that occur late in the
project’s life will have an NPV that is more
sensitive to discount rate changes.
 IRR

• The internal rate of return (IRR) is that discount rate that

causes the NPV of the project to equal zero.
• If IRR > WACC, then the project is acceptable because it
will return a rate of return on invested capital that is
likely to be greater than the cost of funds used to invest
in the project.
Project Evaluation Techniques
Internal Rate of Return (IRR)

CF1 CF2 CF3 CFn

   ...  CF0
(1  IRR ) (1  IRR ) (1  IRR )
1 2 3
(1  IRR ) n

 CF t
or , i 1
 CF0
(1  IRR ) t
 IRR Example
This Example Will Be Used To Demonstrate Alternative Approaches to
Solve for IRR

Problem:
• Initial outlay = $12,000
• After-tax cash flow benefits:
– Year 1 = $5,000
– Year 2 = $5,000
– Year 3 = $8,000
• Cost of Capital = 15%
 IRR Example
Formula-based Approach to the Solution

CF1 CF2 CF3

CF0   
(1  IRR )1 (1  IRR ) 2 (1  IRR ) 3
$5,000 $5,000 $8,000
$12,000   
(1  IRR ) (1  IRR ) (1  IRR ) 3
1 2

The only way you can use the formula is to use the iterative approach t o solving for IRR. That is, substitute different values
for IRR until the mathematic al expression becomes an equality.
 IRR Example
Formula-based Approach to the Solution

CF1 CF2 CF3

CF0   
(1  IRR ) (1  IRR ) (1  IRR ) 3
1 2

$5,000 $5,000 $8,000

$12,000   
(1  IRR )1 (1  IRR ) 2 (1  IRR ) 3

The only way you can use the formula is to use the iterative approach t o solving for IRR. That is, substitute different values
for IRR until the mathematic al expression becomes an equality.

Let IRR  20%

$5,000 $5,000 $8,000
$12,000     $12,268.52
(1.2)1 (1.2) 2 (1.2)3

Since $12,000  $12,268.52 then we need to increase the discount rate to lower the
PV of future cash flows until they equal $12,000.
 IRR Example
Formula-based Approach to the Solution

Let IRR  25%

$5,000 $5,000 $8,000
$12,000     $11,296
(1.25)1 (1.25) 2 (1.25) 3

Since $12,000  $11,296 then we know the IRRis between 20% and 25%.

You can continue to substitute different values into the equation t o iterativel y
find the IRR, or you can use linear interpolat ion to ESTIMATE the approximat e value of the IRR.
 IRR Example
Formula-based Approach to the Solution – Linear Interpolation

Summarizing our results:

IRR is Discount Rate Present Value of Benefits
between 20% $12,268.52
20% and IRR $12,000
25% 25% $11,296

We can now estimate the IRR assuming a linear relationship between PV of benefits (which
isn’t exactly true because compound interest is a curvilinear relationship)

IRR  20 12,000  12,268.50


25  20 11,296  12,268.50
 268.52
IRR  20  5   1.3805
 972.52
IRR  21.38%
 IRR versus NPV

• Both methods use the same basic decision

inputs.
• The only difference is the assumed discount
rate.
• The IRR assumes intermediate cashflows are
reinvested at IRR…NPV assumes they are
reinvested at WACC
– This difference, however, can produce conflicting
decision results under specific conditions
 Evaluating Investment Alternatives
Comparing NPV and IRR
Table 13 - 1 NPV versus IRR
Issue NPV
1. Future cash flows It still works the same for both
change sign accept/reject and ranking
decisions.
2. Ranking projects Higher NPV implies greater
contribution to firm wealth - it is
an absolute measure of wealth.
3. Reinvestment rate Assumes all future cash flows are
assumed for future cash reinvested at the discount rate.
flows received This is appropriate because it
treats the reinvestment of all
future cash flows consistently,
and k is the investor's opportunity
cost.
IRR
Multiple IRRs may result - in this
case, the IRR cannot be used for
either accept/reject or ranking
decisions.
The higher IRR project may have a
lower NPV, and vice versa,
depending on the appropriate
discount rate, and the size of the
Assumes cash flows from each
project are reinvested at that
project's IRR. This is
inappropriate, particularly when
the IRR is high.
 Evaluating Investment Alternatives
NPV and IRR Compared

Which method should be relied upon?

– It depends on which reinvestment assumption is
most realistic.
– Most often, the NPV assumption of reinvestment at
WACC is the most realistic because no rational
manager would reinvest cash flows at rates lower
than the firm’s cost of capital.
– Projects with high IRRs are not common – to
assume that future cash flows will be reinvested at
the inflated IRR rate is probably wrong.
Payback and Discounted Payback

Capital Budgeting, Risk

Considerations and Other Special
Issues
 Payback Method

• This is a simple approach to capital budgeting that is designed

to tell you how many years it will take to recover the initial
investment.
• It is often used by financial managers as one of a set of
investment screens, because it gives the manager an intuitive
sense of the project’s risk.
 Simple Payback Example

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 5
Cost of Capital = N/A

After-tax incremental Cumulative

Year Cashflow Cash Flows PV Factor Cash Flows
0 Initial cost -$100,000 -$100,000
1 ATCF operating benefit $60,000 -$40,000
2 ATCF operating benefit $60,000 $20,000
3 ATCF operating benefit $60,000
4 ATCF operating benefit $60,000
5 ATCF operating benefit $60,000
6 ATCF operating benefit $60,000
Payback period = 1.7 years
 Discounted Payback Example

Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 5
Cost of Capital = 10.0%

Present
After-tax incremental Value of Cumulative
Year Cashflow Cash Flows PV Factor ATCFs Cash Flows
0 Initial cost -$100,000 1 -$100,000 -$100,000
1 ATCF operating benefit $60,000 0.90909091 $54,545 -$45,455
2 ATCF operating benefit $60,000 0.82644628 $49,587 $4,132
3 ATCF operating benefit $60,000 0.7513148 $45,079 $49,211
4 ATCF operating benefit $60,000 0.68301346 $40,981 $90,192
5 ATCF operating benefit $60,000 0.62092132 $37,255 $127,447
6 ATCF operating benefit $60,000 0.56447393 $33,868 $161,316
Payback period = 1.9 years
 Discounted Payback

• Overcomes the lack of consideration of the time

value of money…
• Graphing the cumulative PV of cash flows can
help us see the pattern of cash flows beyond
the payback point.
• If carried to the end of the project’s useful
life…will tell us the project’s NPV (if you are
using the firm’s WACC)
 Profitability Index

• Uses exactly the same decision inputs as NPV

• simply expresses the relative profitability of the projects
incremental after-tax cashflow benefits as a ratio to the
project’s initial cost.

PI = PV of incremental ATCF benefits

PV of initial cost of project

If PI>1, then we accept; because the PV of benefits exceeds the PV of costs.

 Project Evaluation Techniques
Profitability Index (PI)

PV(cash inflows)
PI 
PV (cash outflows)

• PI is a ratio of the present value of benefits to costs.

• As a pure coefficient, as long as it exceeds 1.00 the
project will increase the value of the firm if accepted.
• A PI of more than 1.0 indicates that the project is
expected to earn a return greater than the required
return.
Investment Opportunity Schedule (IOS)

Example:
Consider a firm that has six different capital investment proposals this year.
Each project has it’s own IRR, NPV, PI and capital cost. Each project has the
same risk as the firm as a whole.

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
A $1,500,000 $290,000 7 -$88,159 8.19% 0.94
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
D $70,000 $20,000 7 $27,368 21.08% 1.39
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
F $960,000 $200,000 8 $106,985 12.99% 1.11

13 - 37
Investment Opportunity Schedule (IOS)
Projects Ranked by NPV

Example:
In the absence of capital rationing the projects as ranked by NPV would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
D $70,000 $20,000 7 $27,368 21.08% 1.39
$9,030,000 $811,835
A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Project A would be unacceptable because of a forecast negative NPV

Investment Opportunity Schedule (IOS)
Projects Ranked by IRR

Example:
In the absence of capital rationing the projects as ranked by IRR would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
F $960,000 $200,000 8 $106,985 12.99% 1.11
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Project A would be unacceptable because forecast IRR < WACC.

Investment Opportunity Schedule (IOS)
Projects Ranked by PI

Example:
In the absence of capital rationing the projects as ranked by PI would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
$9,030,000 $811,835

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Project proposal A would be unacceptable because the forecast PI is less than 1.0.
 Ranking of Projects
In the Absence of Capital Rationing

Project NPV IRR PI

1 C D D
2 F C C
3 E E F
4 B F E
5 D B B

Capital Budget $9,369,000 $9,369,000 $9,369,000

Total NPV $679,803 $679,803 $679,803

Clearly, in the absence of capital rationing, all three methods choose value
maximizing projects and reject value-destroying projects.
Investment Opportunity Schedule (IOS)
Projects Selected by NPV under Capital Rationing Limit of $6 million

Example:
Under capital rationing the projects selected by NPV would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
$5,960,000 $735,785
B $3,000,000 $700,000 6 $48,682 10.55% 1.02
D $70,000 $20,000 7 $27,368 21.08% 1.39

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)
Projects Selected by IRR under Capital Rationing Limit of $6 million

Example:
Under capital rationing the projects selected by IRR would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
$5,070,000 $656,168
F $960,000 $200,000 8 $106,985 12.99% 1.11
B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

Investment Opportunity Schedule (IOS)
Projects Selected by PI under Capital Rationing Limit of $6 million

Example:
Under capital rationing the projects selected by PI would be:

Firm's Cost of Capital = 10.00%

Annual
Capital ATCF Useful
Project Initial Cost Benefits Life NPV IRR PI
D $70,000 $20,000 7 $27,368 21.08% 1.39
C $4,000,000 $1,040,000 6 $529,471 14.40% 1.13
$4,070,000 $556,840
F $960,000 $200,000 8 $106,985 12.99% 1.11
E $1,000,000 $290,000 5 $99,328 13.82% 1.10
B $3,000,000 $700,000 6 $48,682 10.55% 1.02

A $1,500,000 $290,000 7 -$88,159 8.19% 0.94

 Ranking of Projects
Assuming a Limit on Capital Expenditures to $6,000,000

Project NPV IRR PI

1 C D D
2 F C C
3 E E

Capital Budget $5,960,000 $5,070,000 $4,070,000

Total NPV $735,785 $656,168 $556,840

Capital rationing is an artificial limit on capex.

Only NPV ranking will ensure maximization of shareholder wealth
under these constrained conditions.
 International Considerations

• Capex decisions involving direct foreign

investment must take into account additional
factors:
– Political risk
– Potential legal and regulatory issues
– Adjust for foreign exchange risk
– Adjust for foreign taxation
– How can the project be financed if local capital
markets are poorly developed?