Chapter 17 Capital Budgeting Analysis CHAPTER PREVIEW The firm’s strategy to meet market challenges is operationalized through its capital budget. Here, business strategy, marketing forecasts, production estimates, accounting, and financial concepts come together as managers evaluate different purchases or strategic thrusts for the firm. The capital budget must relate to the firm’s mission and its abilities to meet competitive challenges. Information from marketing, finance, and production analyses are put together to form cash flow estimates of proposed projects. Project risk considerations enter the capital budget analysis because higher-risk projects should be expected to earn higher returns than lower-risk projects. The capital budget evaluation is done with the goal of identifying projects that will increase shareholder wealth. LEARNING OBJECTIVES • Explain how the capital budgeting process should be related to a firm’s mission and strategies. • Identify and describe the five steps in the capital budgeting process. • Identify and describe the methods or techniques used to make proper capital budgeting decisions. • Explain how relevant cash flows are determined for capital budgeting decision purposes. • Discuss how a project’s risk can be incorporated into capital budgeting analysis. Learning Extension: Estimating Project Cash Flows • Calculate a project’s periodic cash flows given information on a project’s revenue and expense implication for a firm. CHAPTER OUTLINE I. MANAGEMENT OF FIXED ASSETS II. IDENTIFYING POTENTIAL CAPITAL BUDGET PROJECTS III. CAPITAL-BUDGETING PROCESS IV. CAPITAL BUDGETING TECHNIQUES A. Net Present Value B. Internal Rate of Return 1. NPV and IRR C. Modified Internal Rate of Return D. Profitability Index V. CONFLICTS BETWEEN DISCOUNTED CASH FLOW TECHNIQUES VI. PAYBACK PERIOD VII. DIFFERENCE BETWEEN THEORY AND PRACTICE (from 13th Ed Ch 13) A. Safety Margin B. Managerial Flexibility and Options VIII. ESTIMATING PROJECT CASH FLOWS A. Isolating Project Cash Flows 1. Relevant Project Cash Flows 2. Irrelevant Cash Flows IX. APPROACHES TO ESTIMATING PROJECT CASH FLOWS A. Cash Flow from Operations B. Cash Flow from Investment Activities C. Cash Flow from Financing Activities D. An Example E. Depreciation as a Tax Shield X. KEEPING MANAGERS HONEST XI. RISK-RELATED CONSIDERATIONS XII. SUMMARY LEARNING EXTENSION: ESTIMATING PROJECT CASH FLOWS I. PROJECT STAGES AND CASH FLOW ESTIMATION A. Initial Outlay B. Cash Flows During the Project’s Operating Life C. Salvage Value and NWC Recovery at Project Termination II. APPLICATIONS A. Cash Flow Estimation for a Revenue Expanding Project B. Cash Flow Estimation for a Cost-Saving Project C. Setting a Bid Price LECTURE NOTES I. MANAGEMENT OF FIXED ASSETS Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. It usually affects the composition of fixed assets on the balance sheet. A typical capital budgeting project requires a large up-front investment which is followed by a series of cash inflows. The time frame may be a year or many years. Because of the duration of the projects, the time value of money principles should be used to evaluate them. Projects should be chosen to help a firm meet its mission while enhancing shareholder wealth. Some possible capital-budget analyses include 1. Implement replacement/modernization decisions 2. Expand existing product lines 3. Enter new markets 4. Merge or acquire another firm Projects under consideration are either mutually exclusive (only the best project can be chosen) or independent (all projects that add to shareholder wealth can be chosen). (Use Discussion Questions 1 through 3 here.) II. IDENTIFYING POTENTIAL CAPITAL BUDGET PROJECTS The net present value of a project shows its impact on shareholder wealth. Firms should seek positive NPV projects through market research, examining their mission statements, and by SWOT analysis (Strengths, Weaknesses, Opportunities, Threats). Strengths and weaknesses are internal to the firm; opportunities and threats are external to the firm: they involve competitors, the economy, technology, regulations, and so on. Managers will want to seek projects that enhance a firm’s strengths, mitigate its weaknesses, exploit opportunities, and address threats. (Use Discussion Question 4 here.) III. CAPITAL-BUDGETING PROCESS There is a five-stage capital budgeting process: 1. Identification: finding potential value-enhancing projects 2. Development: estimating a potential project’s cash inflows and outflows 3. Selection: applying decision techniques to accept or reject a project 4. Implementation: doing the project 5. Follow-up: audit the progress of spending and cash flows to determine if the project is progressing satisfactorily Multinational firms must consider the added political and currency risks and possible currency blockages that may occur in overseas projects. Three types of data are collected to obtain information needed to analyze a potential project: external economic and political data; the firm’s internal financial data; and nonfinancial data (see Table 17.1). The text provides some example, which can be augmented by an update review of the same and different corporate web sites, to show the relationship between a firm’s mission and its current portfolio of capital budgeting activities. (Use Discussion Questions 5 through 8 here.) IV. CAPITAL-BUDGETING TECHNIQUES Net present value (NPV) is the best selection technique to use because it considers all cash flows, uses the time value of money, has a clear and objective decision rule, and measures the dollar impact of the project on shareholder wealth. The NPV represents the benefit accruing to shareholders from accepting the project. Positive NPV projects should be accepted; negative NPV projects will reduce shareholder wealth and should be rejected. The probability of obtaining an NPV of zero for a capital budgeting project is infinitesimal. The discount rate used to discount the cash flows is the project’s cost of capital. This concept is fully discussed in the Capital Structure and Cost of Capital. It represents the minimum required rate of return on the project in order to pay the firm’s equity and debt investors their required rates of return. Higher (lower) risk projects, as we will see, will have higher (lower) costs of capital. The internal rate of return (IRR) measures the return earned on the funds that remain internally invested in the project. The IRR is a relative measure of a project’s attractiveness; it is possible for a project to have a higher IRR but a lower NPV than another project. Drawing the NPV profile is a good way to motive the discussion of when and why NPV and IRR may disagree on ranking projects. The NPV profile is a good tool to remind students of something they should know from the Bond Valuation discussion: the inverse relationship between value and discount rate. As the discount rate rises the NPV falls—thus the NPV profile is downward sloped. The IRR does have some drawbacks as an evaluation measure—its rankings may disagree with the NPV and it may present situations of more than one answer—multiple IRRs can occur when the cash flows alternative signs more than once (e.g., a negative outflow—the initial investment—followed by positive cash flows and then a negative outflow at project termination). The Modified Internal Rate of Return (MIRR) gives decision-makers a “rate” to compare to the cost of capital or minimum required rate of return that will give answers and rankings consistent with the NPV without the problem of multiple roots/IRRs. The process of computing the MIRR is a bit cumbersome—finding future value of cash inflows, the present value of cash outflows, and then the discount rate that equates the present value of the outflows and the future value of the inflows—but Excel does have an MIRR function to make the process easier, if students are allowed to access spreadsheet software for homework and tests. The profitability index (PI) measures, in present value terms, the benefits earned per each $1 of funds invested in a project. It is a benefit/cost ratio based on the NPV concept. Although they may not agree on project rankings, NPV, IRR, MIRR and PI will always concur as to whether a project is acceptable or not. This chapter benefits from the use of spreadsheet functions to find discounted cash flow measures. (Use Discussion Questions 9 through 12 here.) V. CONFLICTS BETWEEN DISCOUNTED CASH FLOW TECHNIQUES NPV, IRR, MIRR, and PI will always agree on whether a project should be accepted or rejected. So if the firm is considering only independent projects it makes little practical difference which method is used. All of them always give consistent decisions as to whether a given project would increase or decrease shareholder wealth. But when mutually exclusive projects are ranked from most attractive to least attractive, NPV may rate them differently than the other techniques. The main reason for this is that NPV measures one aspect of the project whereas IRR and PI measure another. NPV measures the dollar change in shareholder wealth that arises from undertaking the project. As relative measures of project attractiveness, IRR and PI indicate the rate of profitability a project adds to shareholder wealth, but not the actual dollar amount. A project with a lower IRR or PI may still add more to shareholder value than another mutually exclusive project if the projects have different cash flow patterns, time horizons, or sizes. (Use Discussion Question 13 here.) VI. PAYBACK PERIOD Payback is still a popular method to evaluate projects although it ignores some of the project’s cash flows (those after the payback period); it ignores the time value of money; it has an arbitrary decision rule (accept projects with paybacks less than a management-specified number); and it provides no information about how a project will affect shareholder wealth. Some argue the payback is a rough measure of a project’s liquidity. But if the firm is concerned with liquidity, it should forego the investment and keep its cash to itself! (Use Discussion Question 14 here.) VII. DIFFERENCE BETWEEN THEORY AND PRACTICE Although superior according to our discussion, the NPV is not as widely used in practice as we might expect. Short-cuts (such as payback) and “rates” (such as IRR) are still used—although surveys of management practice show increasing use of DCF techniques and the NPV method. This section examines why methods such as IRR and payback are still popular among practitioners despite the theoretical superiority of the NPV method. We discuss two basic reasons: safety margin and the value of real options (managerial flexibility and options to expand, reduce, stop, and wait) with respect to capital budgeting projects. (Use Discussion Question 15 here.) VIII. ESTIMATING PROJECT CASH FLOWS During the evaluation process, financial analysts will treat the project using the stand-alone principle, seeking to focus on the incremental after-tax cash flows that will occur because of the project. The incremental after-tax cash flows are measured from the firm’s base case, or what the firm’s expected cash flows will be if the project is not implemented. The base case should include the probable competitive deterioration if the firm does nothing. Cash flows the firm should include in its analysis are 1. Cannibalization effects 2. Enhancement effects 3. Opportunity costs Cash flows the firm should not include in its analysis are 1. Sunk costs 2. Financing costs (Use Discussion Questions 16 through 22 here.) IX. APPROACHES TO ESTIMATING PROJECT CASH FLOWS We draw upon a familiar concept from Chapter 13—the Statement of Cash Flows—to show how to estimate periodic cash flows from a capital budgeting project. From the stand-alone principle, each project is similar to a “mini-firm” with its own accounts for working capital accounts, fixed assets, revenues, expenses, and taxes. We extend this by showing how a project’s periodic cash flows are the period-by-period sum of cash flows from operating activities (net income plus depreciation minus changes in net working capital) and cash flows from investing activities (which can include both investments in the project and reductions in project assets via salvage value calculations). The forecasted income statements are used to estimate periodic net income: project sales −project costs −depreciation EBIT = EBT (as financing costs are not included in capital budgeting cash flow analysis) −Taxes Net income The forecasts of periodic balance sheets are used to estimate changes in working capital (typically accounts receivable, inventory, and accounts payable). Cash flow from operations is computed as Net income+depreciation+current asset/liability sources–current asset/liability uses which is the same as: Net income + depreciation – the change in net working capital Cash flow from investing activities is simply the additional funds invested each period in the project or the funds recovered each period from selling the project’s assets at market value or salvage value. There are other formulas and short cuts to use to estimate operating cash flow. One method results in the formula (sales – costs) (1 – T) + depreciation tax shield – changes in NWC The depreciation tax shield, T . Depreciation, is the cash tax savings the firm receives from its (non-cash) depreciation expense. An important point to emphasize to students is that these are merely estimates of what analysts feel is the most likely outcome for the project’s sales, costs, and cash flows. The uncertainty in these estimates can be seen by using sensitivity or scenario analysis with spreadsheets. The risk of the cash flows will be reflected in the management’s choice of a risk-adjusted discount rate for the project, the subject of the next section. (Use Discussion Questions 23 and 25 here.) X. KEEPING MANAGERS HONEST As estimating cash flow inputs may be more art than science it is subject to abuse—intentional or accidental by well-meaning managers. Managers should be evaluated on the accuracy of their cash flow estimates. This creates two effects. First is that managers are evaluated on their analysis and upper management can learn who is more accurate at estimating cash flows. Second, it provides an audit/feedback loop so managers can learn from their prior experiences. They can learn what went well and why and what estimates proved incorrect and why. (Use Discussion Question 26 here.) XI. RISK-RELATED CONSIDERATIONS Project’s discount rates must be adjusted for the project’s risk level. Otherwise, with NPV, high-risk projects will be overvalued and low-risk projects will be undervalued. One method of determining risk-adjusted discount rates is to classify projects into risk categories, each with its own discount rate, as seen in Table 17.8 (Use Discussion Question 27 here.) DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by capital budgeting? Briefly describe some characteristics of capital budgeting. Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. Capital budgeting projects usually require large initial investments, and may involve acquiring or constructing plant and equipment. A project’s expected time frame may be as short as a year or as long as 20 or 30 years. Projects may include implementing new production technologies, new products, new markets, or mergers. 2. Why is proper management of fixed assets crucial to the success of a firm? The profitability of a firm is affected by the success of management in making capital budgeting decisions. A firm’s long-run strategy is implemented through capital budgeting. 3. How do “mutually exclusive” and “independent” projects differ? With mutually-exclusive projects, competing projects all have the same purpose or aim (for example, a new plant location, or computer system); selecting one eliminates the others from further consideration. If projects are independent, there is no relationship between them, so all acceptable projects (positive NPV) can be chosen. 4. Where do businesses find attractive capital-budgeting projects? Business managers need to search for projects which are related to the firm’s present lines of business or future plans. One popular corporate planning tool, MOGS (Mission, Objectives, Goals, and Strategies), develops project plans that fit well with firm plans. A firm should have a MOGS plan, or something similar to it, in place to give direction to company planning and to help the firm’s officers identify potential capital budgeting projects. Firms should seek positive NPV projects through market research, examining their mission statements, and by SWOT analysis (Strengths, Weaknesses, Opportunities, Threats). 5. Briefly describe the five stages in the capita- budgeting process. a. Identification: finding potential value-enhancing projects b. Development: estimating a potential project’s cash inflows and outflows c. Selection: applying decision techniques to accept or reject a project d. Implementation: doing the project e. Follow-up: auditing the progress of spending and cash flows to determine if the project is progressing satisfactorily 6. Identify some capital budgeting considerations that are unique to multinational corporations. Multinational firms must consider political and currency risks, foreign taxes, and regulations. 7. What kinds of financial data are needed in order to conduct the analysis of a project? Data needed include investment costs; estimates of revenues, costs, and after-tax cash flows; cost of capital estimate; publicly available data on competitors’ plans and operating results. 8. What kinds of nonfinancial information are needed in order to conduct the analysis of a project? Nonfinancial information needed includes information on available distribution channels, labor force quality and quantity, labor-management relations, pace of technological change, competitive analysis of the industry, and the potential reaction of competitors. 9. What is meant by a project’s net present value? How is it used for choosing between projects? Net present value is the present value of a project’s cash flows minus the initial outlay. It measures the change in shareholder wealth if the project is chosen by the firm. All positive NPV projects should be done by the firm. 10. Identify the internal rate of return method and describe how it is used in making capital budgeting decisions. The internal rate of return is the discount rate where the NPV is zero. It measures the return on the funds that remain internally invested in the project. Acceptable projects have IRRs greater than the project’s cost of capital. 11. How does the modified internal rate of return measure improve upon the IRR measure? It always provides a single answer, regardless of the project’s cash flow pattern (e.g., alternating positive and negative cash flows). The IRR method sometimes has multiple IRRs for such projects. Another advantage of the MIRR method is, for projects of comparative size, its rankings of projects will always concur with those of the NPV method. 12. Describe the term “profitability index” and explain how it is used to compare projects. The profitability index is the present value of a project’s cash flows divided by the initial outlay. It measures, in present value terms, the benefits of a project per $1 of initial cost. Projects are acceptable if their PIs exceed one. 13. Why do the NPV, IRR, and profitability index technique sometimes rank projects differently? There are three basic reasons why rankings may differ. First, differences in ranking can arise if projects have different cash flow patterns—that is, if some projects have more cash flow occurring earlier (or later) than other projects. Projects with earlier and larger cash flows may have higher IRR rankings than those based upon the NPV method. Second, shorter projects can free up invested funds more quickly and have a higher IRR ranking than its NPV ranking. Third, differently sized projects can lead to different rankings; smaller projects may have higher IRR and PI rankings than those determined by the NPV method. 14. Describe the payback period method for making capital budgeting decisions. The payback measures how long it takes for a project to repay its investment. The firm will accept projects with paybacks less than a management-specified maximum. 15. Why might managers want to use other techniques besides NPV to make capital budgeting decisions? One reason is the desire by managers for an intuitive safety margin. An IRR of 12% with a cost of capital of 11% provides an intuitive (or “gut”) feel that the cash flow estimates need to be accurate; if they are underestimated only a little the project may turn out to have an IRR below the cost of capital. An NPV of, say, $100,000 provides no such intuitive feel—although one means of so doing is to divide the NPV by the original investment (or present value of all outflows). A second reason is the difference in size between projects. A large project may have the highest NPV if it is the largest project. Managers should look at the NPVs possible from different combinations of projects to determine if a portfolio of smaller projects has a combined NPV greater than the larger project’s. Thirdly, NPV calculations do not indicate the value of managerial flexibility. Project NPV can be enhanced by expanding a successful project—and delaying or cancelling one with actual cash flows that are below target. 16. How is the “stand-alone principle” applied when evaluating whether to invest in projects? Under the stand-alone principle, a project’s cash flows are viewed in isolation, uncontam-inated by cash flows from the firm’s other activities. 17. What are the three types of relevant cash flows to be considered in analyzing a project? Incremental after-tax cash flows, cannibalization or enhancement effects, and opportunity costs are considered relevant when analyzing a project’s cash flows. 18. Label each of the following as a cannibalization effect, enhancement effect, or neither. Explain your answers. a. A computer manufacturer seeks to produce a high quality engineering work station, thinking that consumers will believe the firm's standard PC products will also be of higher quality. Enhancement; positive reviews for the high-end product will make consumers view the firm’s standard products has higher-value products. b. An airline offers taxicab service to and from the airport. Enhancement; it combines two related services and ease customers’ driving/parking needs when traveling via airline. c. A gas station adds service bays and a small convenience store. Enhancement; customers can stop and get an oil change, tire rotation, and other car service done at a location they frequent and at a business with which they are already familiar. The convenience store will provide drinks, snacks, and some grocery items for customers stopping for gas—or entice in-and-out shoppers to fill up their gas tanks before leaving. d. A mainframe computer manufacturer begins to sell personal computers. Will not be cannibalization as mainframe computers (large business) and PCs (individuals, workstations) will not directly compete. There may be some enhancement effects to rounding out product line offerings and some benefits if the mainframes are perceived to be of good quality. At worst, there will be little connection between the two markets and the final result will be neither cannibalization nor enhancement. e. A snack food manufacturer starts marketing a new line of fat-free snacks. Enhancement; protect market share from a shift in consumer tastes and preferences. f. A firm seeks to export its products to foreign countries. Enhancement; it expands a market for current products to new geographic regions. 19. What types of cash flows are considered to be irrelevant when analyzing a project? Sunk costs and financing costs are considered to be irrelevant when analyzing a project’s cash flows. 20. “Our firm owns property around Chicago that would be an ideal location for the new warehouse. And since we already own the land there isn’t any cash flow needed to purchase it.” Do you agree or disagree with this statement? Explain. Disagree. The existing land’s value should be considered an opportunity cost in the warehouse’s capital budgeting analysis. Rather than used as a warehouse site the firm faces the alternative of selling the land at its market value and using the proceeds of the sale for the firm’s purposes. 21. “Our bank will finance the product expansion project with at a loan interest rate of 10 percent. Make sure the project’s cash flow estimates include this interest expense.” Do you agree or disagree? Explain. Disagree. Financing costs are not considered when estimating a project’s cash flows. They are incorporated into the project’s cost of capital when evaluating its impact on shareholder value. 22. Classify each of the following as a sunk cost, an opportunity cost, or neither. a. The firm has spent $1 million thus far to develop the next-generation robotic arm; it is now examining whether the project should continue. Sunk cost; what should determine whether the project goes forward is future cash flow expectations and their net present value. b. A piece of ground owned by the firm can be used as the site for a new facility. Opportunity cost; the firm should consider its market value as a cost of using the site for the new facility. c. It is anticipated another $200,000 of R&D spending will be needed to work out the bugs of a new software package. Sunk cost; what should determine whether the project goes forward is future cash flow expectations and their net present value. 23. How is a project’s cash flow statement similar to that of a firm? How is it different? A firm’s Statement of Cash Flows uses historical information on balance sheets and income statements to estimate cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities to explain the differences over time in a firm’s cash account. Using the same concepts, forecasts over time of a project’s balance sheet accounts and income statement (revenues and expenses) can be used to estimate cash flow from operations and cash flows from investing activities. The resulting sum of the operating and investing cash flows are the project’s periodic cash flows, which are used to determine its NPV. Cash flows from financing activities are not part of a project’s cash flows, as the implications of financing a project are reflected in the discount rate, or cost of capital, used to discount the project’s cash flows. 24. Why is the change in net working capital included in operating cash flow estimates? Changes in current asset and current liability accounts can add or detract from cash flows. For example, an increase in sales revenues may result in lower increase (or even a decrease) in cash inflows if the amount of credit sales causes accounts receivable to rise sufficiently. Similarly, an increase in costs may not have immediate negative cash flow implications if the added expenses create increases in accounts payable. 25. Why is depreciation considered to be a “tax shield”? Its effect is to reduce taxable income as it is subtracted as an expense although there is no cash outlay for it. The reduction in taxable income leads to a cash savings via lower taxes. 26. What is a way to keep managers accountable for their capital budgeting forecasts and estimates? One method is to require a “paper trail” of cash flow estimates and rationales related to the project. As the project moves forward the revenue and cost estimates can be audited to determine which were overestimated and which were estimated correctly. Managers can be held accountable for their decisions and learn from their mistakes—as well as from what went right with the project. 27. What is a risk-adjusted discount rate? How are risk-adjusted discount rates determined for individual projects? A risk-adjusted discount rate raises or lowers a project’s discount rate from the firm’s overall cost of capital to reflect a project’s risk level. Higher (lower) risk projects should have higher (lower) discount rates. Otherwise, with NPV, high-risk projects will be over-valued and low-risk projects will be undervalued. One method of determining risk-adjusted discount rates is to classify projects into risk categories, each with its own discount rate, as seen in Table 17.6. PROBLEMS AND ANSWERS 1. Find the NPV and PI of a project that costs $1,500 and returns $800 in Year 1 and $850 in Year 2. Assume the project’s cost of capital is 8 percent. PV of cash inflows = $800/1.08 + $850/(1.08)2 = $1,469.48 PV of cash outflows = $1,500 NPV = $1469.48 – 1,500 = $–30.52 PI = $1,469.48/1,500 = 0.98 2. Find the NPV and PI of an annuity that pays $500 per year for eight years and costs $2,500. Assume a discount rate of 6 percent. PV of cash inflows = $500 × PVIFA(6%,8) = $500 × 6.210 = $3,105 PV of cash outflows = $2,500 NPV = $3,105 – 2,500 = $605 PI = $3,105/2,500 = 1.242 3. Find the IRR of a project that returns $17,000 three years from now if it costs $12,000. FV = PV × (1 + r)n = $17,000 = 12,000 = (1 + IRR)3 IRR = 12.31% 4. Find the IRR and MIRR of a project if it has estimated cash flows of $5,500 annually for seven years if its year zero’s investment is $25,000. PVIFA = PV annuity/Annual receipt = $25,000/5,500 = 4.545 n = 7; PVIFA falls between 12% (4.564) and 14%(4.288) Calculator or spreadsheet solution: 12.13% MIRR: Present value of outflows = $25,000 Future value of inflows is a future value of a 7 year annuity of $5,500: PMT = 5,500 N = 7 I = 10% gives a future value of $52,179.44 Solving for MIRR we have $52,179.44 = $25,000(1+MIRR)7 MIRR=11.08% 5. For the following projects, compute NPV, IRR, MIRR, profitability index, and payback. If these projects are mutually exclusive, which one(s) should be done? If they are independent, which one(s) should be undertaken? a. b. c. d. Year 0 – 1,000 –1,500 –500 –2,000 Year 1 400 500 100 600 Year 2 400 500 300 800 Year 3 400 700 250 200 Year 4 400 200 200 300 Discount rate 10% 12% 15% 8% Project a NPV = $400 × PVIFA (10%,4) – 1,000 = $400 × 3.170 – 1,000 = $1,268 – 1,000 = $268 PI = $1,268/1,000 = 1.268 IRR = 21.86% (calculator or spreadsheet solution) MIRR = 16.7% (spreadsheet solution) Payback = $1,000/400 = 2.5 years Project b NPV = $500(1/1.12) + $500 (1/1.12)2 + $700 (1/1.12)3 + $200(1/1.12)4 – 1,500 = $446.43 + 398.60 + 498.25 + 127.10 – 1,500 = $ –29.62 PI = $1,470.38/1,500 = 0.98 IRR = 10.99% (calculator or spreadsheet solution) MIRR = 11.4% (spreadsheet solution) Payback = 2.71 years Project c NPV = 100(1/1.15) + 300(1/1.15)2 + 250(1/1.15)3 + 200(1/1.15)4 – 500 = $86.96 + 226.84 + 164.38 + 114.35 – 500 = $92.53 PI = $592.53/500 = 1.19 IRR = 23.13% MIRR = 20.0 (spreadsheet solution) Payback = 2.4 years Project d NPV = $600(1/1.08) + 800(1/.108)2 + 200(1/1.08)3 + 300(1/1.08)4 – 2,000 = $555.56 + 685.87 + 158.77 + 220.51 – 2,000 = $ –379.30 PI = $1,620.70/2,000 = 0.81 IRR = undefined; when discount rate = 0, NPV 0, so project is acceptable. c. Calculate the approximate internal rate of return. Calculator or spreadsheet solution: 19.86%. 19. Assume the financial manager of the Sanders Electric Company in Problem 6 believes that Project M is comparable in risk to the firm’s other assets. In contrast, there is greater uncertainty concerning Project O’s after-tax cash inflows. Sanders Electric uses a 4 percentage point risk premium for riskier projects. The firm’s cost of capital is 10 percent. a. Determine the risk-adjusted net present values for Project M and Project O, using risk-adjusted discount rates where appropriate. NPV (risk-adjusted, M) = $1,040 (remains the same as answer to Problem 8b) NPV (risk-adjusted, O) = $10,000 × PVIFA (14%,5) + 5,000(PVIF(14%,3) + PVIF(14%,4) + PVIF(14%,5) – 46,000 = $10,000 × 3.433 + 5,000(.675 + .592 + .519) – 46,000 = 43,260 – 46,000 = $ –2,740 b. Are both projects acceptable investments? Which one would you choose? Project M is acceptable, since it’s risk-adjusted NPV is positive. Project O is no longer acceptable, since it’s risk-adjusted NPV is negative. 20. The Biotech Corporation has a basic cost of capital of 15 percent and is considering investing in either or both of the following projects. Project Hate will require an investment of $453,000, while Project Latke’s investment will be $276,000. The following after-tax cash flows (including the investment outflows in year zero) are estimated for each project. Year Project Hate Project Latke 0 $ –453,000 $ –276,000 1 132,000 74,000 2 169,500 83,400 3 193,000 121,000 4 150,700 54,900 5 102,000 101,000 6 0 29,500 7 0 18,000 a. Determine the present value of the cash inflows for each project and then calculate their net present values by subtracting the appropriate dollar amount of capital investment. Which, if either, of the projects is acceptable? By calculator or spreadsheet: Hate PV inflows = $506,724.83 NPV = $53,724.83 Latke PV inflows = $308,094.31 NPV = $32,094.31 Hate and Latke have positive NPVs. If they are independent, both should be accepted. If they are mutually exclusive, Hate should be accepted because of its higher NPV. b. Calculate the internal rates of return for Project Hate and Project Latke. Which project would be preferred? By calculator or spreadsheet: Hate IRR = 20.0% LoTek IRR = 19.3% Both HiTek and LoTek have IRRs exceeding the 15% cost of capital. If independent, both should be accepted. If mutually exclusive, HiTek is preferred. c. Now assume that BioTek uses risk-adjusted discount rates in order to adjust for differences in risk among different investment opportunities. BioTek projects are discounted at the firm’s cost of capital of 15 percent. A risk premium of 3 percentage points is assigned to LoTek types of projects, while a 6-percentage point risk premium is used for projects similar to HiTek. Determine the risk-adjusted present value of the cash inflows for LoTek and HiTek and calculate their risk-adjusted net present values. Should BioTek invest in either or even both HiTek and LoTek projects? HiTek required return = 15% + 6% = 21% NPV of HiTek by (calculator or spreadsheet) = $ –10,887.61 LoTek required return = 15% + 3% = 18% NPV of LoTek (by calculator or spreadsheet) = $20,376.95 Only LoTek has a positive NPV, so it is the only acceptable project. SUGGESTED QUIZ 1. Interpret in a sentence or two the following: a. NPV = +$8 million b. IRR = 13.5 percent c. PI = 1.76 d. Payback period = 1.2 years Solution a. Shareholder wealth is expected to rise by $8 million if the firm undertakes the project. b. The funds that remain invested in the project earn a return of 13.5 percent. c. The project returns $1.76, in present value terms, for every $1 invested in it. d. The project recovers its cost in 1.2 years. 2. What is the relationship between NPV, IRR, and PI? 3. A firm is considering a project that will cost $1 million and generate after-tax cash flows of $300,000 for five years. If the project’s discount rate is 12 percent, what is its NPV? It’s IRR? Its profitability index? Its payback? Solution: PV(inflows) = $300,000 × PVIFA(12%, 5 years) = $300,000 × 3.605 = $1,081,500 NPV = $1,081,500 – $1,000,000 = $81,500 IRR (calculator or spreadsheet solution) = 15.24 percent Profitability index = $1,081,500/$1,000,000 = 1.0815 Payback = $1,000,000/$300,000 = 3 1/3 years 4. Why should discounted cash flows be used to evaluate capital budgeting projects? Learning Extension 17 Estimating Project Cash Flows I. PROJECT STAGES AND CASH FLOW ESTIMATION A. Initial Outlay B. Cash Flows During the Project’s Operating Life C. Salvage Value and NWC Recovery at Project Termination II. APPLICATIONS A. Cash Flow Estimation for a Revenue Expanding Project B. Cash Flow Estimation for a Cost-Saving Project C. Setting a Bid Price I. PROJECT STAGES AND CASH FLOW ESTIMATION Too many times the process of estimating cash flows becomes too mechanical: here are the inputs, now “plug-and-chug” into the appropriate formula to estimate a project’s investing and operating cash flows. We realize in an introductory finance class we can do little more than this, especially on exams. But we should increase students’ awareness for where the numbers come from. This is a way to refer back to the opening discussion in the chapter about information needs and sources. There is much hard work—and some “guesstimating” that goes into cash flow inputs. But this also offers you a chance to relate the topic of estimating cash flows to other majors or business courses (most notably marketing and operations) to show that finance cannot be done in a vacuum. What happens at the end of a project can cause some confusion among students. If assets are depreciated during the life of a project and are then to be sold, we need to “make right” with the tax authorities. If we depreciated the asset too quickly (through no fault of our own, of course; the IRS determines the asset classes and the depreciation schedules on most assets) and its end-of-project market value is greater than its book value, we will recover some depreciation expenses when we sell it. Since depreciation expense reduces our ordinary business income we must pay ordinary income tax on any recovered depreciation. On the other hand, selling an asset for less than book value means the firm did not depreciate the asset fast enough—so it gets a benefit when selling the asset for less than book value. It gets to deduct the unexpensed depreciation (that is, book value minus selling price) from income when the asset is sold; this deduction will lower the firm’s ordinary income taxes, just as prior depreciation expenses, taken under the IRS schedule, lowered the firm’s ordinary income and taxes. Two interesting twists can occur at the end of a project’s time horizon. One, the unlikely case, is that the project’s assets can be sold for more than its cost. This means we have to pay ordinary income taxes on the fully-recovered depreciation expense and pay capital gains tax on the difference between the end-of-project sales price and the firm’s original cost. This situation is so unlikely we do not discuss it in the book but it does happen—one notable example may be the value of land that may rise in value during a project’s life (and of course, land cannot be depreciated, only the buildings that rest on it may be depreciated). The other twist is that the project is expected to be on-going and not have a foreseeable termination date—such may be the case of creating a new product line, expanding into a new market, or building a new factory or distribution point. In such cases we use a tool we learned in stock valuation—the constant dividend growth model, adapted to the situation of constant operating cash flow growth over time. (Use Discussion Questions 1 and 2 here.) II. APPLICATIONS With a lot of “theory” and concepts dealing with estimating cash flows we end the chapter with examples of three different types of projects: revenue-expanding, cost-saving, and setting a bid price. We review revenue-expanding and cost-saving projects using a process that involves estimating 1. initial outlay for the project (typically an investing cash flow) 2. the project’s operating cash flows 3. the salvage or terminal value of the project and 4. using a chapter 13 capital budget evaluation technique to determine if the project harms or enhances shareholder value. This shows students the mechanical methods to compute an NPV, IRR, etc. are the tail-end of the capital budgeting process—that much analysis precedes the (now) rather “simple” task of discounting cash flows to determine their impact on shareholder value. Determining a bid price changes the above steps. To determine a bid price we use the first and third steps of the above process first. Next we use the values for the initial outlay and salvage/terminal value to estimate the operating cash flows that result in a zero NPV for the project. Once the zero-NPV operating cash flow is computed, we can plug in the known information into our operating cash flow equation: (Sales – Costs – Depreciation) (1 – t) + Depreciation – change in net working capital to estimate the sales revenue required for a zero NPV. If the number of units is know, the bid price is the zero-NPV sales revenue divided by the number of units. (Use Discussion Questions 3 through 5 here.) DISCUSSION QUESTIONS 1. What information sources are used to develop estimates for a project's a. initial outlays? Information sources include engineering estimates for the design or modification of buildings and/or equipment; market value estimates of land, buildings, and equipment; and construction costs. Such information can be obtained from collecting bids, working with brokers to estimate land/building costs, architectural firm building estimates, and the market value of old equipment to be disposed of. b. operating life? Engineering and market estimates as well as the firm’s strategic intent with the project. c. salvage value? Ask experts in the secondary market for the assets; forecast future scrap prices; and consider the tax implications of the sales. In the case of an on-going project, estimate cash flows for a certain number of years and then assume a future growth rate in order to estimate its terminal value. 2. Why might there be tax implications when an asset is sold at the termination of a capital budgeting project? If assets are depreciated during the life of a project and are then to be sold, we need to adjust the final selling price for recovered depreciation (if price > book value) or unexpensed depreciation (if price < book value). If its selling price exceeds book value we will recover depreciation expenses and we must pay ordinary income tax on any recovered depreciation. If the selling price is less than book value the firm did not depreciate the asset fast enough so it gets to deduct the unexpensed depreciation (that is, book value minus selling price) from income when the asset is sold. This deduction will lower the firm’s ordinary income taxes. 3. Explain the process to estimating cash flows for a revenue-enhancing project. The process involves estimating 1. initial outlay for the project (typically an investing cash flow) including depreciable (e.g., equipment and installation costs) and expensed outlays (such as training costs) 2. the project’s operating cash flows based on estimates of incremental sales, costs, depreciation, taxes, and changes in net working capital arising from the project. 3. the salvage or terminal value of the project based upon the expected value of assets at the end of the project and their initial costs. 4. Explain the process to estimating cash flows for a cost-saving project. The process involves estimating 1. initial outlay for the project (typically an investing cash flow) including depreciable (e.g., equipment and installation costs) and expensed outlays (such as training costs) 2. the project’s operating cash flows based on estimates of incremental costs, depreciation, taxes, and changes in net working capital arising from the project. Typically cost-savings projects have no incremental sales. 3. the salvage or terminal value of the project based upon the expected value of assets at the end of the project and their initial costs. 5. Explain the process to estimating a bid price by estimating zero-NPV cash flow needs. The process involves estimating 1. initial outlay for the project (typically an investing cash flow) including depreciable (e.g., equipment and installation costs) and expensed outlays (such as training costs) 2. the salvage or terminal value of the project based upon the expected value of assets at the end of the project and their initial costs. We find the present value of these estimates to compute the operating cash flows that result in a zero NPV for the project. Once the zero-NPV operating cash flow is computed, we can plug in the known information into our operating cash flow equation: (Sales – Costs – Depreciation) (1 – t) + Depreciation – change in net working capital to estimate the sales revenue required for a zero NPV. If the number of units is know, the bid price is the zero-NPV sales revenue divided by the number of units. PROBLEMS 1. Suppose the Quick Towing Company purchases a new tow truck. The old truck had a book value of $1,000 and was sold for $1,420. If Quick Towing is in the 34 percent marginal tax bracket, what is the tax liability on the sale of the truck? What is the after-tax cash flow on the sale? The selling price exceeds book value so some depreciation is recovered; taxes owed on the sale will be: ($1,420 - $1,000) x 0.34 = $142.80. The net selling price is $1,420 – 142.80 = $1,277.20 2. Hammond's Fish Market just purchased a $30,000 fork lift truck. It has a five-year useful life. The firm’s tax rate is 25 percent. a. If the fork lift is straight-line depreciated, what is the firm’s tax savings from depreciation? Depreciation expense - $30,000/5 = $6,000 Depreciation tax shield = 0.25 x $6,000 = $1,500. b. What will be its book value at the end of year 3? After 3 years the accumulated depreciation is 3 x $6,000 = $18,000 so the truck’s book value is $30,000 - $18,000 = $12,000. c. Suppose the fork-lift can be sold for $10,000 at the end of three years. What is its after-tax salvage value? From part b, the book value is $12,000. The after-tax salvage value is: = Price − T(Price − BV) $10,000 – (0.25)($10,000 - $12,000) = $10,000 + $500 = $10,500 3 . Lisowski Laptops is examining the possibility of manufacturing and selling a notebook computer that is compatible with both PCs and MacIntosh systems and that can receive television signals. Its estimated selling price is $2,500. Variable costs (supplies and labor) will equal $1,500 per unit, and fixed costs per year would approximate $200,000. Up-front investments in plant and equipment will total $270,000, which will be straight-line depreciated over three years. The initial working capital investment will be $100,000 and will rise proportionately with sales. Bill, the CEO, forecasts sales of the laptop will be 50,000 units the first year, 60,000 units the second, and 45,000 units the third year, at which time product life cycles would require closing down production of the model. At that time, the market value of the project's assets will be about $70,000. LL's tax rate is 40% and its required return on projects such as this one is 17%. Should they offer the new computer? Price: $2,500 per unit Investment: $270,000 Tax rate: 40% Variable costs: $1,500 per unit Project life: 3 years Fixed costs: $200,000 Depreciation: $90,000 Salvage value $70,000 Initial working capital: $100,000 Year Sales (units) Change in working capital 1 $50,000 $100,000 2 $60,000 $120,000 =$100,000($60,000/$50,000) 3 $45,000 -$120,000 recover all NWC investment Investing cash flow: Year 0 ($270,000) Operating cash flow: Year 1 Year 2 Year 3 Sales $125,000,000 $150,000,000 $112,500,000 less variable costs $75,000,000 $90,000,000 $67,500,000 less fixed cost $200,000 $200,000 $200,000 less depreciation $90,000 $90,000 $90,000 equals earnings before taxes $49,710,000 $59,710,000 $44,710,000 x (1-t) 60% 60% 60% equals net income $29,826,000 $35,826,000 $26,826,000 plus depreciation $90,000 $90,000 $90,000 less change in net working capital $100,000 $20,000 ($120,000) equals OCF $29,816,000 $35,896,000 $27,036,000 Salvage cash flow: Year 3 Market value: $70,000 Book value: $0 fully depreciated After-tax salvage value: $42,000 Cash Flow summary Initial ($270,000) Year 1 $29,816,000 Year 2 $35,896,000 Year 3 (operating+salvage) $27,078,000 NPV $68,342,981.04 Yes, they should offer the new computer Required rate of return: 17% 4. Preston Industries' current sales volume is $100 million a year. Preston is examining the advantages of EDI (electronic data interchange). The technology will allow Preston to electronically communicate with suppliers and customers, send and receive purchase orders, invoices, and cash. It will save Preston money by lowering costs in the purchasing, customer service, accounts payable, and accounting departments. Initial estimates are that savings will equal $100,000 a year. Investment in EDI technology will include $500,000 in depreciable expenses and $100,000 in non-depreciable expenses. Assets will be depreciated on a straight-line basis for four years. Implementation of EDI is expected to reduce Preston's net working capital by $200,000. Because of changing technology, Preston's president, Carol, wants to estimate the effect of switching to EDI on shareholder wealth over a four-year time horizon assuming that advances in technology will make the equipment worthless at the end of four years. At a 30% tax rate and 13% required rate of return, should Preston Industries switch to EDI? Project life: 4 years Tax rate: 30% Required rate of return: 13% Investing cash flow: Depreciable expenses $500,000 Depreciation per year: $125,000 Non-depreciable exp: $100,000 Total: $600,000 Operating cash flow: Year 1 Year 2 Year 3 Year 4 Sales $0 $0 $0 $0 no change in sales less costs -$100,000 -$100,000 -$100,000 -$100,000 cost savings less depreciation $125,000 $125,000 $125,000 $125,000 equals earnings before taxes ($25,000) ($25,000) ($25,000) ($25,000) Subtracting a cost savings results in adding the number x (1-t) 70% 70% 70% 70% equals net income ($17,500) ($17,500) ($17,500) ($17,500) Loss leads to lower taxes plus depreciation $125,000 $125,000 $125,000 $125,000 less change in net working capital ($200,000) $0 $0 $200,000 Reduction in year 1 only; restored in year 4 equals OCF $307,500 $107,500 $107,500 ($92,500) Salvage cash flow: Year 4 Market value: $0 Book value: $0 fully depreciated After-tax salvage value: $0 Cash Flow summary Initial ($600,000) Year 1 $307,500 Year 2 $107,500 Year 3 $107,500 Year 4 (operating+salvage) ($92,500) NPV at 13% ($225,917.02) No, they should not switch 5. Bart and Morticia, owners of the prestigious Gomez-Addams Office Towers, are concerned about high heating and cooling costs and client complaints of temperature variation within the building. They commissioned an engineering study by Frasco-Prew Associates to identify the cause of the problems and suggest corrective action. Frasco-Prew's basic recommendation is that a new HVAC (heating, ventilation, and air conditioning) system, featuring electronic climate control, be installed in the Towers. Over the next four years, the engineers estimate a new system will reduce heating and cooling costs by $125,000 a year. Cost of the new system will be $500,000 and can be depreciated over four years. Using a 25% tax rate and a 14% required return, should Bart and Morticia change the HVAC system? Use a four year time horizon. Project life: 4 years Tax rate: 25% Required rate of return: 14% Investing cash flow: Depreciable expenses $500,000 Depreciation per year: $125,000 Operating cash flow: Year 1 Year 2 Year 3 Year 4 Sales $0 $0 $0 $0 no change in sales less costs -$125,000 -$125,000 -$125,000 -$125,000 cost savings less depreciation $125,000 $125,000 $125,000 $125,000 equals earnings before taxes $0 $0 $0 $0 Subtracting a cost savings results in adding the number x (1-t) 75% 75% 75% 75% equals net income $0 $0 $0 $0 Loss leads to lower taxes plus depreciation $125,000 $125,000 $125,000 $125,000 less change in net working capital $0 $0 $0 $0 No effect on NWC equals OCF $125,000 $125,000 $125,000 $125,000 Salvage cash flow: Year 4 Market value: $0 No information is given--assume zero Book value: $0 fully depreciated After-tax salvage value: $0 Cash Flow summary Initial ($500,000) Year 1 $125,000 Year 2 $125,000 Year 3 $125,000 Year 4 (operating+salvage) $125,000 NPV at 14% ($135,786.15) 6. Casey's Baseball Bats is planning to begin exporting their product to the Asian market. They estimate up-front expenses of $1 million this year (year 0) and $3 million next year (year 1). Operating cash flows in years 2, 3, and 4 will be (in dollars) $100,000; $200,000; and $400,000, respectively. After year 4, they expect operating cash flows to grow at 10% a year indefinitely. If 15% is the required return on the project, what is its NPV? Required rate of return: 15% Given cash flow data: Cash flow Terminal Value TOTAL Year 0 -$1,000,000 -$1,000,000 Year 1 -$3,000,000 -$3,000,000 Year 2 $100,000 $100,000 Year 3 $200,000 $200,000 Year 4 $400,000 $8,800,000 $9,200,000 constant growth rate: 10% Terminal value: $400,000(1.10)/(0.15-0.10) in year 4 NPV: $1,858,552 7. The No-Shoplift Security Company is interested in bidding on a contract to provide a new security system for a large department store chain. The new security system would be phased into 10 stores per year for five years. No-Shoplift can purchase the hardware for $50,000 per installation. The labor and material cost per installation is approximately $15,000. In addition, No-Shoplift will need to purchase $100,000 in new equipment for the installation, which will be depreciated to zero using the straight-line method over five years. This equipment will be sold in five years for $25,000. Finally, an investment of $50,000 in net working capital will be needed. Assume that the relevant tax rate is 34 percent. If the No-Shoplift Security Company requires a 10 percent return on its investments, what price should it bid? Tax rate: 34% Required Return 10% Project life: 5 years Initial investment: New equipment $100,000 Depreciation: $20,000 Salvage value: $25,000 Installation cost: NWC investment: $50,000 (year 1 only, recovered at end) Hardware $50,000 per installation Labor and materials cost $15,000 per installation Initial cash flows: Investing Operating Salvage Total Cash Flow (Sales, Costs) NWC Year 0 (100,000) ($100,000) Initial investment Year 1 X (50,000) X-$50,000 increase in NWC of $50,000 Year 2 X X Year 3 X X Year 4 X X Year 5 X $50,000 $16,500 X+$66,500 Salvage is $25,000-(0.34)($25,000-0) Converting known cash flows to present values at a 10% discount rate:: Total Cash Flow Year 0 ($104,163) Year 1 X Year 2 X Year 3 X Year 4 X Year 5 X What 5-year annuity has a present value of $104,163 so the project's NPV = 0? Financial calculator: PV -$104,163 i 10% N 5 PMT or CPT PMT $27,478.01 This is the operating cash flow without NWC effects as they are already incorporated into the previous analysis. Using this operating cash flow we need to work backwards to estimate the bid price We must work from the bottom (step 1) to the top (step 8) to determine the minimum bid price for 10 stores per year in order to generate operating cash flows (excluding net working capital) sufficient to earn a zero NPV. Sales $681,330.32 Step 8: Sales must equal the sum of pre-tax earnings, depreciation, and costs -Cost $650,000.00 Step 7: expenses are estimated at $65,000 per store; 10 stores/year -Depreciation $20,000.00 Step 6: depreciation was estimated at $20,000 per year Earnings before taxes $11,330.32 Step 5: Before-tax sum is the after-tax sum divided by (1-t) when the tax rate is 34% Net income $7,478.01 Step 4: As OCF is the sum of this number, depreciation, and the change in NWC, this number must equal OCF - change in NWC - depreciation +Depreciation $20,000.00 Step 3: depreciation was estimated at $20,000 per year -change NWC $0.00 Step 2: there is no change in net working capital--already included in OCF determination Operating CF $27,478.01 Step 1: Start here with OCF of $27,478.01 Working backward, from bottom to top, we see Sales revenue must equal $681,330.32 This equals the annual bid price. Bid price/store: $68,133.03 Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288
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