Course 3: Capital

Budgeting
Analysis
  Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e.
assets that provide cash flow benefits for more than one year. We are trying to answer
the following question:
 Will the future benefits of this project be large enough to justify the investment given the risk
involved?

 It has been said that how we spend our money today determines what our value will be
The Three Stages of
Capital Budgeting tomorrow. Therefore, we will focus much of our attention on present values so that we
Analysis can understand how expenditures today influence values in the future. A very popular
approach to looking at present values of projects is discounted cash flows or DCF.
However, we will learn that this approach is too narrow for properly evaluating a project.
We will include three stages within Capital Budgeting Analysis:
 Decision Tree Analysis for Knowledge Building

 Option Pricing to Establish Position

 Discounted Cash Flow (DCF) for making the Investment Decision

  DCF: The riskiness of an asset is encapsulated in one number – a higher discount rate,
lower cash flows or a discount to the value – and the computation almost always
requires us to make assumptions (often unrealistic) about the nature of risk.

 Real options: It is the only one that gives prominence to the upside potential for risk,
Adjusting the based on the argument that uncertainty can sometimes be a source of additional value,

value of a risky especially to those who are poised to take advantage of it.

assets  Decision tree(Scenario Analysis): Decision trees allow us to not only consider the risk in
stages but also to devise the right response to outcomes at each stage. The analysis
could provide information on what the value of the asset will be under each outcome or
at least a subset of outcomes.
  Decision-tree analysis is one type of scenario analysis companies
use to analyze capital budgeting risk.
 First, a company attempts to outline several different scenarios that
Decision-tree Analysis might occur over the life of the timberland project.

 The next step is to assign probabilities to each scenario and then

calculate expected profitability based on either the company’s cash flow
or net income.
  Assume Wood Products Company is considering purchasing timberland that would
provide a future source of timber supply for the company’s operations over the next 10
years. Based on current environmental regulations, the company has forecasted present
values using the most likely future cash flows. These values are shown in Table 1.
 The company can either buy the timbers as need for the after 10 years or buys the timberland
today.

 Financial standpoint, the two alternative timber acquisition strategies would be equal.

Eg
 However, we assume the environmental regulation will change in the next 10 years therefore affects
the supply and price of the timbers.
 This will lead to uncertainties.
 A decision tree is a way of diagramming this type of uncertainty so that each branch of the diagram
represents one of the possible scenarios.
Preferred
strategies in
different
scenarios
  Pros
Pros and Cons  Can model uncertainty explicitly
 Show the most important links between current and future decisions.
of using  Cons
Decision tree  When you concern about several areas of uncertainty such as
regulation, inflation, the economy, and export demand, for example—all
analysis at the same time. The complexity of the decision-tree analysis will
expand exponentially.
  Real options are a right but not an obligation to make a business decision.
 Describe the capacity of individuals or entities to learn and their willingness
Real Options and the ability to modify behavior based upon that learning.
Types
  Option to expand: To make an investment or undertake a project in the future to expand
the business operations (a market test that suggests that consumers are far more
receptive to a new product which could be used as a basis for expanding the scale of
the project).
 Option to abandon:To cease a project or an asset to realize its salvage value (a
manufacturer can opt to sell old equipment).
 Option to wait :Deferring the business decision to the future (a fast-food chain
Types considers opening new restaurants this year or in the next year).
 Option to contract: Shutting down a project at some point in the future if conditions are
unfavorable (a multinational corporation can liquidate its assets in a country with an
unstable political situation and transfer the assets back to parent company).
 Option to switch: Altering modes of operation by paying a switching cost. (The option to
start or shutter operations, to enter or exit an industry, or to consume one type of fuel or
another)
  We can now make an investment decision based on Discounted
Cash Flows

Stage 3:
Discounted Cash Flows
  Discounting refers to taking a future amount and finding its value
today. Future values differ from present values because of the time
value of money. Financial management recognizes the time value of
money because:

Time Value of  1. Inflation reduces values over time: i.e. $ 1,000 today will have less
Money value five years from now due to rising prices (inflation).
 2. Uncertainty in the future: i.e. we think we will receive $ 1,000 five
years from now, but a lot can happen over the next five years.
 3. Opportunity Costs: $ 1,000 today is worth more to us than $ 1,000
five years from now because we can invest $ 1,000 today and earn a
return.
Discount rate
reference table
(one time CF)
Discount rate
reference table
(annuity )
  One question that we must ask in capital budgeting is what is relevant. Here are some
examples of what is relevant to project cash flows:
 1. Depreciation: Capital assets are subject to depreciation, and we need to account for depreciation
twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on
project revenues, and we add back depreciation to arrive at cash flows because depreciation is a non-
Calculating the cash item.

Discounted  2. Working Capital: Major investments may require increases to working capital. For example, new
production facilities often require more inventories and higher salaries payable. Therefore, we need to

Cash Flows of consider the net change in working capital associated with our project. Changes in net working capital
will sometimes reverse themselves at the end of the project.

Projects:  3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer
support services. However, the subjective nature of overhead allocations may not make any difference

Relevancy at all. Therefore, you need to assess the impact of your capital project on overhead and determine if
these costs are relevant.

 4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to
investors. The best way to account for financing costs is to include them within our discount rate. This
eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and
discounting at our cost of capital which also includes our financing costs.
  A sunk cost refers to money that has already been spent and
Calculating the which cannot be recovered.

Discounted  Sunk costs are those which have already been incurred and
Cash Flows of which are unrecoverable.
 In business, sunk costs are typically not included in
Projects: consideration when making future decisions, as they are seen
as irrelevant to current and future budgetary concerns.
Sunk Cost  Sunk costs contrast with relevant costs, which are future costs
that have yet to be incurred.
eg1
eg2
eg3
  Understand the relevant cost and sunk cost within free cash flow

 Calculating the free cash flow : projection period , terminal period

 Determine the WACC

recap
 Derive PV and NPV to find if the project is worth investing
FCF
  We will receive $ 5,788 of cash flow each year by investing in this
new assembly machine. Since we have a salvage value, we have a
terminal cash flow associated with this project.

Terminal Value
  We will assume that our cost of capital is 12%.

Present value
  Comparing the initial investment with the DCF

 Treatment to the initial cash outlay

Net  All cash paid out to invest in the project and place it into service, such
Investment as installation, transportation, etc.
 Net proceeds from the disposal of any old equipment that will be
replaced by the new equipment.
 Any taxes paid and/or tax benefits received from making the investment.
Net
investment
• Sales of machinery should be levied in accordance with VAT not
sales tax
• Usually, we have tax exemption for selling PPE (if salvage value
is less than original purchase price)
• What is the revised net investment?
  NPV=DCF-Net investment
 These amounts are derived by looking at three different types
of cash flows:
NPV  1. Relevant cash flows during the life of the project.
 2. Terminal cash flows at the end of the project.
 3. Initial cash flows (net investment).

 Should we invest in the previous example?

  The internal rate of return is a metric used in financial analysis to
estimate the profitability of potential investments. The internal rate of
return is a discount rate that makes the net present value (NPV) of
all cash flows equal to zero in a discounted cash flow analysis.
• IRR is the annual rate of growth an investment is expected to generate.
• IRR is calculated using the same concept as NPV, except it sets the
NPV equal to zero.
Other • IRR is ideal for analyzing capital budgeting projects to understand and
compare potential rates of annual return over time.
Methods:
IRR
Eg

The IRR (6.43%) is less than our cost of capital (12%).

Therefore, we would not invest in this project.
Comparing IRR
with NPV
  In order to eliminate the reinvestment rate assumption, we will modify the Internal Rate
of Return so that the reinvestment rate is our cost of capital. This will give us a more
accurate IRR for our project.

 Mathematically, the calculation of the MIRR is expressed using the following equation

MIRR
 Where:

• FVCF – the future value of positive cash flows discounted at the reinvestment rate

• PVCF – the present value of negative cash flows discounted at the financing rate

• n – the number of periods

  The final economic criteria we will use is the Discounted Payback
Period. Payback refers to the number of years it takes to recover our
net investment. In our previous example (Example 6), we could use
a simple payback calculation as follows:
Discounted
payback  $ 24,100 / $ 5,788 = 4.2 years

period  However, this method does not recognize the time value of money
and as we previously indicated, we must consider the time value of
money because of inflation, uncertainty, and opportunity costs.
Therefore, we will use the discounted cash flows to calculate the
payback period (discounted payback period).
Under the Discounted Payback Period, we would never receive a
payback on our project; i.e. the total to date present cash flows
never reached $ 24,100 (net investment). If we had relied on the
regular payback calculation, we would falsely assume that this
project does payback in the fourth year.
  Use NPV or MIRR when possible
Summary  Use Discounted payback period for selective industries , eg
Nature resources..
  Whenever we analyze a capital project, we must consider
unique factors. A discussion of all these factors is beyond the
Additional scope of this course. However, three common factors to
Considerations in consider are:
Capital  Compensating for different levels of risks between projects.
Budgeting Analysis
 Recognizing risks that are specific to foreign projects.
 Adjusting capital budgeting analysis by looking at the actual
results.
  Capital investments in other countries can involve additional risks.
Whenever we invest in a foreign project, we want to focus on the
values that are added (or subtracted) to the Parent Company. This
makes us consider all relevant risks of the project, such as
exchange rate risk, political risk, hyper-inflation, etc. For example,
International Projects
the discounted cash flows of the project are the discounted cash
flows of the project to the foreign subsidiary converted to the
currency of the home country of the Parent Company at the current
exchange rate. This forces us to consider exchange rate risks and
its impact to the Parent Company.
  One of the most important steps in capital budgeting analysis is to
follow-up and compare your estimates to actual results. This post
analysis or review can help identify bias and errors within the overall
process. A formal tracking system of capital projects also keeps
Post analysis everyone honest. For example, if you were to announce to everyone
that actual results will be tracked during the life of the project, you
may find that people who submit estimates will be more careful. The
purpose of post analysis and tracking is to collect information that
will lead to improvements within the capital budgeting process.
 Q:Will you buy hybrid cars if the perceived probabilities of
clean energy bill get passed increased to 50%?

Including real Q:What is the option of assets flexibility in this question？

Does introduction this option increased our investment
option into NPV?

DCF Q:How does adding the option to delay purchase

increased our project’s NPV?
evaluation
(Hybrid car Q:Once you are allowed to wait for another year, whether
the bill would pass become a realized event. Why do we
subsidy) still need to consider probabilities of bill passing or not
passing in our NPV calculation as shown in figure 3?