Capital Budgeting, Risk Considerations - PowerPoint Presentation

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Capital Budgeting, Risk Considerations - PPT Presentation

and Other Special Issues 13 13 1 Describe the capital budgeting process and explain its importance to corporate strategy 13 2 Identify and apply the main tools used to evaluate investments ID: 619750

capital investment canada npv investment capital npv canada 3rd cleary sons edition john wiley amp booth project 000 cash

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Slide1
Slide2

Capital Budgeting, Risk Considerationsand Other Special Issues

Describe the capital budgeting process and explain its importance to corporate strategy.

Identify and apply the main tools used to evaluate investments.

Analyze independent projects and explain how they differ from interdependent projects.

Explain what capital rationing is and how it affects firms’ investment criteria.

Explain the importance of international foreign direct investment both inside and outside Canada.

13.6

Understand how the modified internal rate of return (

MIRR

) is calculated and why this

represents a

conceptual improvement over the way the

IRR

is calculated.Slide3

13.1 CAPITAL EXPENDITURES

Capital expenditures are a firm’s investments in long-lived or fixed assets, which may be:

Tangible, such as property, plant and equipment

Intangible, such as research and development knowledge, patents, copyrights, trademarks, brand names and franchise agreements

Capital expenditures decisions determine the future direction of the company and are among the most important that a firm can make because they often:Involve a very significant outlay of money and managerial timeTake many years to demonstrate their returnAre irrevocableSignificantly alter the risk of the entire firm because of their size and long-term nature

Booth • Cleary – 3rd Edition

13.1 CAPITAL EXPENDITURES

Capital budgeting is the process through which a firm makes capital expenditure decisions, and involves identifying and evaluating investment alternatives, implementing the chosen proposals, and monitoring implemented decisions

Booth • Cleary – 3rd Edition

Michael Porter’s Five Forces Model identifies five critical factors that determine the attractiveness of an industry:

Entry barriersThreat of substitute products

Bargaining power of buyers

Bargaining power of suppliers

Rivalry among existing competitorsBooth • Cleary – 3rd Edition

13.1

CAPITAL EXPENDITURESSlide6

Companies do exert control over how they strive to create a competitive advantage within their industry. They can strive for:

Cost leadership (i.e., be the lowest-cost producer)Product differentiation (i.e., have products considered unique)Once attained, a competitive advantage is difficult to sustain and requires on-going planning and investmentCapital expenditure decisions must be made with a strategic focus and be subject to rigorous financial analysis

Booth • Cleary – 3rd Edition

13.1

CAPITAL EXPENDITURESSlide7

Bottom-up analysis is an investment strategy in which capital expenditure decisions are considered in isolation without regard for whether the firm should continue in its particular business or for general industry and economic trends

Top-down analysis is an investment strategy that focuses or strategic decisions, such as which industries or products the firm should be involved in, looking at the overall economic picture

Booth • Cleary – 3rd Edition

13.1

CAPITAL EXPENDITURESSlide8

Capital expenditure decisions, like security valuation, must take into account the timing, magnitude, and riskiness of net incremental after-tax cash flow benefits that an initial investment is forecast to produce

Unlike security valuation, however, analysts can change the underlying cash flows by changing the structure of the project to impact its feasibility and profitabilityAll

discounted cash flow (DCF)

methods require an estimate of the initial investment, the net incremental after-tax cash flows, and the required rate of return on the project for the discount rate

Booth • Cleary – 3rd Edition8

13.1

CAPITAL EXPENDITURESSlide9

13.2 EVALUATING INVESTMENT ALTERNATIVES

Figure 13-1 shows the cash flow pattern for a traditional capital expenditure:

where :

t = the estimated after-tax future incremental cash flow at time tCF

0 = the initial after-tax incremental cash outlay

We will consider four DCF methods for evaluating investment alternatives: net present value (NPV), internal rate of return (IRR), payback period and discounted payback period, and profitability index (PI).

Booth • Cleary – 3rd Edition

The firm’s cost of capital determines the minimum rate of return that would be acceptable for a capital project

The weighted average cost of capital (WACC) is the discount rate (k) used in NPV analysis, assuming the risk of the project being evaluated is similar to the risk of the overall firm, and the hurdle rate for IRR analysisIf the risk of the project differs from the risk of the overall firm, however, a risk-adjusted discount rate (RADR) should be used.

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide11

RADRs can be estimated using two techniques:

Use the CAPM after determining the project’s beta. This approach involves forecast ROA that must be regressed against the ROA of the market index, and estimation errors can be significant.

Use a pure-play approach where you find the cost of capital of another firm operating in the industry associated with the project. The key to this approach is that the firm must not be diversified across industries but truly represent an investment solely in that industry.

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide12

Net Present Value (NPV

) AnalysisUse Equation 13-1 to calculate net present value (

NPV

)

:Essentially, the net present value (NPV) is the present value of all benefits (net cash inflows) minus the present value of costs (net cash outflows)

If PV(benefits) > PV(costs), then NPV > 0 and the project is acceptable because it will add value

If PV(benefits) < PV(costs), then NPV < 0 and the project should not be accepted because it will destroy value

NPV is an absolute measure, expressed in present dollars, of the net incremental benefit the project is forecast to bring shareholders

In a perfectly efficient market, the total value of the firm should rise by the value of the NPV if the project is undertaken

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide13

Net Present Value (NPV) Analysis

Example: Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. Using a 15% discount rate, determine the project’s NPV.Solution by Formula:

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide14

Net Present Value (NPV

) AnalysisSolution Using a Financial Calculator:

Solution Using Excel:

=NPV(rate, value 1, value 2, …, value n)

=NPV(0.15, 5000, 5000, 8000) = $13,388.67, the present value of future cash flows

Then, subtract the initial outlay of $12,000 to find NPV

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide15

Net Present Value (NPV) Analysis

An NPV profile is a set of NPVs for a project created by varying the discount rate used to find the present value of the cash flowsAn NPV profile is also the slope of the line created when the results are graphed; the longer the life of a project, the steeper the slope of the NPV profile.

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide16

The Internal Rate of Return (

IRR)The internal rate of return (IRR) is the discount rate that causes the NPV of the project to equal zero:

If the IRR > WACC, then the project is acceptable because it is forecast to yield a rate of return on invested capital that is greater than the cost of the fund invested in the project

If the IRR < WACC, the project should not be accepted because the investment will not earn its cost of capital

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide17

The Internal Rate of Return (IRR

)Example: Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. The cost of capital is 15%. Determine the project’s IRR.There is no closed-form formula solution for IRR. It can be solved iteratively, but technology expedites the process significantly.

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide18

Solution Using a Financial Calculator:

Solution Using Excel:=IRR(value 0, value 1, value 2, …, guess), guess can be blank

=IRR(-12000, 5000, 5000, 8000) = 21.31282726%

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide19

A Comparison of NPV

and IRRBoth methods use the same basic decision inputsThe difference is the assumed discount rate: the IRR assumes intermediate cash flows are reinvested at the IRR while the NPV assumes that they are reinvested at the WACC

This difference can produce conflicting decision results under specific conditions (see Table 13-1, next slide):

Evaluating two or more mutually exclusive investment proposals

NPV profiles of the projects have different slopes and cross at a positive NPVThe cost of capital (relevant discount rate) is lower than the crossover discount rate

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide20

Booth • Cleary – 3rd Edition

20© John Wiley & Sons Canada, Ltd.

13.2 EVALUATING INVESTMENT ALTERNATIVES

A Comparison of

NPV

and

IRRSlide21

A Comparison of NPV

and IRRIn Figure 13-2 the IRR of B is 15% while the IRR of A is only 12%, so IRR would suggest that B is better than ABut, notice that the NPV of A is greater when the discount rate is lower than the 9% crossover rate

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide22

A Comparison of NPV

and IRRBoth NPV and IRR use the same inputsNPV measures in absolute terms the estimated increase in the value of the firm today that the project is forecast to produce, and assumes that cash flows are reinvested at WACC

IRR estimates the project’s rate of return and assumes that cash flows produced by the project are reinvested by the firm at the project’s IRR

The reason for the different accept/reject decisions is the different reinvestment rate assumptions used by the two techniques

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide23

A Comparison of NPV

and IRRWhich method should be relied upon?It depends which reinvestment assumption is more 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

If projects with high IRRs are rare, then reinvestment may not be possible

Booth • Cleary – 3rd Edition

23© John Wiley & Sons Canada, Ltd.

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide24

A Comparison of NPV

and IRRDespite the inherent superiority of the NPV approach, chief financial officers continue to use other approaches and do not necessarily favour NPV over IRR

Perhaps the reason for this is that it is difficult for people to understanding what a positive NPV really means

Booth • Cleary – 3rd Edition

24© John Wiley & Sons Canada, Ltd.

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide25

Payback Period and Discounted Payback Period

The payback period is a simple approach to capital budgeting that is designed to tell you how many years it will take to recover the initial investmentThe payback period 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

The

discounted payback period

overcomes the lack of consideration of time value of money that is problematic with the simple payback periodGraphing the cumulative present value of cash flows can help identify the pattern of cash flows beyond the payback pointIf carried to the end of the project’s useful life, it will tell us the project’s NPV if the WACC is used as the discount rate

Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide26

Payback Period and Discounted Payback PeriodExample: Determine the payback and discounted payback for a project that costs $100,000 to implement and gives $60,000 after-tax cash flows for six years

Solution: the payback period is 1.7 years and the discounted payback period is 1.9 yearsBooth • Cleary – 3rd Edition

Year

Discounted

Cumulative

Cumulative Discounted

-$100,000

$60,000

$54,545

-$40,000

-$45,455

$60,000

$49,587

$20,000

$4,132

$60,000

$45,079

$60,000

$40,981

$60,000

$37,255

$60,000

$33,868

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide27

The Profitability Index

(PI) The profitability index (PI) uses exactly the same decision inputs as the NPV

The PI simply expresses the relative profitability of the project’s incremental after-tax cash flow benefits as a ratio to the project’s initial cost:

If PI > 1, accept the project because the PV(Benefits) > PV(Costs)

If PI < 1, do not accept the project because the PV(Benefits) < PV (Costs)Booth • Cleary – 3rd Edition

13.2 EVALUATING INVESTMENT ALTERNATIVESSlide28

13.3 INDEPENDENT AND INTERDEPENDENT PROJECTS

Independent projects have no relationship with one another; therefore, the decision to implement one project has no impact on the decision to implement another project.

Example: Building a store in Ottawa is independent of building a store in Edmonton

Contingent projects

, on the other hand, are projects where the acceptance of one requires the acceptance of another, either as a prerequisite or simultaneously

Example: Building a retail outlet in Edmonton requires warehouse space in Edmonton

Booth • Cleary – 3rd Edition

13.3 INDEPENDENT AND INTERDEPENDENT PROJECTS

Mutually exclusive projects are substitutes where the decision to accept one project automatically means all other substitute proposals are rejected

Example: A commercial development on a parcel of land in Edmonton means an apartment building will not be built there

Booth • Cleary – 3rd Edition

There are two approaches to adjust for unequal lives among mutually exclusive projects:

The chain replication approach finds a time horizon into which all the project lives under consideration will divide equally (i.e., their lowest common multiple) and then assumes each project repeats until it reaches this horizon. This implicitly assumes the projects are repeatable on the same terms into the future.

The

equivalent annual NPV (EANPV)

approach compares projects by finding the NPV of the individual projects and then determining the amount of an annuity that is economically equivalent to the NPV generated by each project over its respective time horizon. Equation 13-4:

Booth • Cleary – 3rd Edition

13.3

INDEPENDENT AND INTERDEPENDENT PROJECTSSlide31

13.4 CAPTIAL RATIONING

Capital rationing is the corporate practice of limiting the amount of funds dedicated to capital investments in any one year

It is academically illogical: why would a manager not invest in a project that will offer a greater return than the cost of capital used to finance it?

In the long-run, it could threaten a firm’s continuing existence through the erosion of its competitive position

But the firm may have owners who do not want to raise additional external equity because it will mean ownership dilution of their shareThe firm may also have so many worthy investment projects that taking advantage of all of them exceeds the firm’s short-term managerial capacityUnder capital rationing the cost of capital is no longer the appropriate opportunity cost IRR may have more validity because the firm may be able to reinvest its cash flows at rates that are higher than the cost of capital

Booth • Cleary – 3rd Edition

The profitability index may also be a useful starting point because it ranks projects on PV per unit of investmentIn the absence of capital rationing, NPV, IRR and PI will select value-maximizing projects.

Figure 13-4 shows Tim Horton’s investment opportunity scheduleBooth • Cleary – 3rd Edition

13.4

CAPTIAL RATIONINGSlide33

An investment opportunity schedule (IOS) is a prioritized list of capital projects, ranked from highest to lowest with the cumulative investment required also listed

Investments can be ranked according to any metric, but only NPV ensures maximization of shareholder wealthExample: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment

Booth • Cleary – 3rd Edition

Project

Initial

Cost

($)

Annual ATCF

($)

Useful Life

NPV

($)

IRR

(%)

1,500,000

290,000

-88,159

8.19

0.94

3,000,000

700,000

48,682

10.55

1.02

4,000,000

1,040,000

529,471

14.40

1.13

70,000

20,000

27,368

21.08

1.39

1,000,000

290,000

99,328

13.82

1.10

960,000

200,000

106,985

12.99

1.11

13.4

CAPTIAL RATIONINGSlide34

Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investmentIn the absence of capital rationing, all three methods choose value maximizing project and reject value destroying projects

Booth • Cleary – 3rd Edition

Rank

NPV

IRR

Rejected

13.4

CAPTIAL RATIONINGSlide35

Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investmentWith only $6 million to allocate only NPV ensures maximization of shareholder wealth

Booth • Cleary – 3rd Edition

Rank

NPV

IRR

n/a

Capital Budget

$5,960,000

$5,070,000

$4,070,000

Total NPV

$735,785

$656,168

$556,840

13.4

CAPTIAL RATIONINGSlide36

13.5 INTERNATIONAL CONSIDERATIONS

Capital investment decisions that involve foreign investment should taking into account additional factors:Political riskPotential legal and regulatory issues

Adjustments for foreign exchange risk

Adjustments for foreign taxation

Sources of financing if local capital markets are poorly developed or unsuitableExport Development Canada (EDC) is a federal crown corporation that helps Canadian firms export and make foreign direct investment (FDI)EDC provides insurance products to mitigate some risks of FDIFDI outside of Canada is a growing phenomenon as Canadian companies are increasing seeking international investment opportunitiesEDC encourages Canadian companies to look beyond the U.S. for FDI

Booth • Cleary – 3rd Edition

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